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1 Private equity in Japan Fuelling the next M&A wave? In co-operation with Ernst & Young Transaction Advisory Services Co, Ltd Freshfields Bruckhaus Deringer Shinsei Bank

2 Private equity in Japan Fuelling the next M&A wave? Contents 3 Preface 4 Executive summary 6 Introduction 8 Where did it come from? 12 Everyone into the game 17 Finding the inside track 20 Through the gate, now what? The Economist Intelligence Unit

3 Private equity in Japan Fuelling the next M&A wave? 2006 Economist Intelligence Unit. All rights reserved. All information in this report is verified to the best of the author s and the publisher s ability. However, the Economist Intelligence Unit does not accept responsibility for any loss arising from reliance on it. Neither this publication nor any part of it may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the Economist Intelligence Unit. 2 The Economist Intelligence Unit 2006

4 Private equity in Japan Fuelling the next M&A wave? Preface Private equity in Japan, Fuelling the next M&A wave? is an Economist Intelligence Unit briefing paper, written in co-operation with Ernst & Young Transaction Advisory Services, Freshfields Bruckhaus Deringer and Shinsei Bank. The Economist Intelligence Unit bears sole responsibility for this report. The Economist Intelligence Unit s editorial team gathered data, conducted interviews and wrote the report. The findings and views expressed in this report do not necessarily reflect the views of the sponsors. Ron Bevacqua was the author of the report. Laurel West was the editor. The cover image was created by Stephen Webster of Worldwide Hideout. Our thanks are due to all interviewees for their time and insights. The Economist Intelligence Unit

5 Private equity in Japan Fuelling the next M&A wave? Executive summary M&A activity continues to accelerate in Japan, and has caught the attention of the world's larger private equity houses. According to Thomson Financial, a data provider, announced M&A deals in Japan doubled to more than 21trn (US$181bn) in 2005, with a record 3,002 deals (Japanese companies and funds buying Japanese companies and foreigners buying Japanese companies). For a country in which M&A was practically a fourletter word only a few years ago, this explosion in activity points to nothing less than a revolution in Japanese corporate management. Even more remarkable has been the rise of private equity. Virtually non-existent as late as 1996, private equity firms are now a fixture at auctions for the cast-off subsidiaries of larger conglomerates, and increasingly an accepted (or at least tolerated) part of the business community. There are now an estimated 100 private equity funds in Japan with over 2trn ready for investment equivalent to 10% of Japan s entire M&A market. Yet private equity deals remain relatively scarce by our estimates, buyouts by private equity accounted for just 4% of all M&A deals in 2004 and Even if deals involving minoritystake capital participation are included, private equity accounts for just over 15% of all M&A deals involving a Japanese target. Moreover, most deals have been quite small. While these figures might give private equity firms cause for caution, one figure does not: according to the Centre for Asia Private Equity Research, in 2005 divestments from private equity buyouts returned just over 1trn (US$8.6bn) on invested capital of 340bn, a return on investment of 3.4 times. Will private equity one day fuel an even bigger wave of M&A in Japan, as many market observers have predicted for several years? It may, but that day appears to be a long way off. This briefing paper argues that if the day does arrive, it may not hold much reward for traditional, independent funds. Among the obstacles for them are: Competition from well-backed, wellconnected domestic buyers attached to major financial institutions. The mini boom in private equity investment in the past few years has for the most part been fuelled by funds tied to Japanese financial institutions, both national and regional in scale. Although such players are tiny by US standards and started relatively late, their solid market coverage and networking ability make them formidable competitors. They source deals from their parent bank s network and often get them on an exclusive basis rather than through auction. Difficulty establishing relationships and finding talent. While the availability of distressed assets may have played a role in the number of private equity deals in Japan so far, some observers believe that the Japanese market has matured beyond the distressed stage. The development of proprietary deal flows is now of paramount importance. Large fund houses could have an edge in this regard. For example, Ripplewood, a US fund renowned for its turnaround of the Long-term Credit Bank of Japan (now Shinsei), has been successful in large part based on its board of high-powered, well-connected Japanese advisers (see box, page 18). Lesser firms, particularly those who want to remain independent, will have it much harder. They must give sellers a reason to choose 4 The Economist Intelligence Unit 2006

6 Private equity in Japan Fuelling the next M&A wave? them over other firms, and money is not the answer. They must bring added value such as a network or special expertise in a specific industry, or access to new markets or to experienced management. Developing the talent to be able to offer such value is never easy in any market but is especially difficult in Japan, where there are few experienced turnaround specialists. Lingering resistance to the concept of handing substantial management control of healthy firms to outsiders. This is perhaps the main reason why there are so few big deals in Japan. Indeed, the biggest recent private equity deals such as Kanebo, Sanyo, Fujita Corporation and Seibu still involved distressed assets. A regulatory outlook that seems destined to discourage traditional private equity firms. In reaction to the Livedoor accounting scandal, the Financial Services Agency, which oversees the financial sector, is seeking to regulate limited liability partnerships, through which private equity operates, more actively. It wants to impose minimum capitalisation, licensing and other requirements which would favour institutionally backed private equity firms, which are run more like their listed parent corporations. Many observers of the Japanese market say that by far the biggest barrier to private equity is the fact that pure financial transactions are an anathema to the Japanese way of doing business. In some ways, however, private equity firms may suit Japanese sellers better than strategic buyers. For example: Reliance on personal relations. The reliance of private equity players on personal relations at the start of negotiations and their emphasis on confidentiality and exclusivity fits with the characteristics of Japanese-style M&A. An alternative to rivals and management overhaul. Since private equity firms do not run business lines, selling to them means not selling directly to a hated rival. In the case of a management buy-out (MBO), it means the managers remain independent. Some, notably Nobuo Sayama, president of advisory firm GCA and a godfather of private equity in Japan, believe there will be a major shake-out of funds in the next few years, and a consequent rise in the sophistication of the market. Until then, however, unsophisticated and unspecialised activity are likely to remain features of the private equity market, slowing attempts to build the kind of value-added skills which make the industry a viable alternative counterparty to strategic sellers. All eyes are now on the really big global players like KKR, Texas Pacific Group and Bain Capital as they get their recently announced Japanese operations up and running. So far, few big names, with the exceptions of Carlyle, Cerberus Capital Management and Goldman Sachs, have been able to seal deals in Japan. There are early signs that the new entrants may pursue a common strategy tying up with the private-equity spin-offs of Japanese financial institutions. CVC, for example, has announced plans to join forces with Nomura Principal Finance to fund a management buyout of Skylark, a restaurant operator, estimated to be valued at US$2.5bn. Sir Deryck Maughan of KKR has indicated that his firm plans to do the same, building on global financing relationships that KKR has established over the years with Japanese banks to gain access to deals in Japan. The Japanese funds, in return, presumably would rely on KKR s expertise in turning around companies, something which they themselves lack. These giants are obviously hedging their bets. They are not running dedicated Japan funds, which by definition require them to invest in Japan. The Economist Intelligence Unit

7 Private equity in Japan Fuelling the next M&A wave? Introduction For most private equity firms, the Japanese market is a lot like golf is for beginners. Many shots end up in the rough. But every once in a while one goes so spectacularly well that it encourages players to stay in the game. Surely, they think, good shots will come more consistently with time. For now, however, it seems that private equity players will need to spend more time on the driving range. Although M&A activity in Japan continues to accelerate, making it the secondlargest market by volume and third-largest by value, private equity deals remain relatively scarce. A classic example of frustration is provided by private equity s front-page role in the M&A equivalent of a hole-in-one Softbank's acquisition of the Japanese subsidiary of UK telecoms firm Vodafone. Worth an estimated 1.25trn (US$10.8bn), it was the biggest M&A deal in Japanese history. Adding to the excitement was a last-minute bid from a team of financial investors led by American private equity firm Cerberus Capital Management. Vodafone used Cerberus to force Softbank to pay more than it had initially planned, but there was very little evidence that Cerberus s counter-bid was seriously considered by Vodafone Japan s board. The bid eventually failed. Indeed, for the moment enthusiasm is outstripping deal making, particularly for the big private equity houses. The capitalisation of private equity funds is enormous in the context of the M&A market in Japan. According to Thomson Financial, a data provider, announced M&A deals in Japan doubled to more than 21trn (US$181bn) in Yet by 2006 there were an estimated 100 private equity funds in Japan with over 2trn ready for investment, according to Nihon Keizai Shimbun, a Japanese economic newspaper. The capital in private equity funds is therefore equivalent to more than 10% of Japan s entire M&A market. Given the amount of leverage in the average private equity deal, this would enable private equity to cover the lion s share of the M&A market if only it could find something to buy. So far the actual involvement of private equity in the M&A market remains relatively small. In terms of the number of deals, data compiled by M&A advisory firm Recof show that deals involving a financial buyer accounted for just over 15% of all domestic M&A activity (Japanese companies and funds buying Japanese companies and foreign companies and funds buying Japanese companies) in both 2004 and This figure is overstated, however, according to the traditional definition of private equity, since it includes a significant portion of minority-stake capital participation deals. A closer look at the Recof data suggests that just one-quarter of all deals by financial buyers in those years involved a complete takeover (equivalent to 4% of total domestic M&A deals). Even if transactions in which the acquirer became the lead or secondlargest minority shareholder were included, they would still account for only about half of total deals involving financial buyers, or roughly 7% of the entire domestic M&A deal flow. Even this figure is probably overstated because many of the financial buyers in the Recof data are not private equity funds. Data from other sources show varying levels of activity, depending on what types of deals are included. But the conclusion is the same: private equity accounts for a small 6 The Economist Intelligence Unit 2006

8 Private equity in Japan Fuelling the next M&A wave? Two stories More deals, smaller value Japan sponsor-backed* deals Deal value, US$ bn * Acquisitions, including add-on and portfolio transactions, and exits by private equity firms Source: Dealogic Deals of significance large private equity deals in Japan* Value, US$ bn Number of deals Number of deals * Significant transactions including those with participation by foreign private equity firms. Excludes domestic venture capital deals. Source: Centre for Asia Private Equity Research portion of the M&A market (see chart, Two stories). Moreover, the average size of all M&A deals in Japan is still quite tiny. Data from Thomson Financial suggest that the average M&A deal in Japan is worth only 7bn, half the size of the average deal in the US or UK. This presents an obstacle to many private equity firms, especially foreign ones, because the fixed costs of doing a transaction, such as due diligence, often make small deals an inefficient use of their capital. While these figures might give private equity firms cause for caution, one figure does not: the Centre for Asia Private Equity Research calculates that in 2005 divestments returned just over 1trn (US$8.6bn) on invested capital of 340bn, a return on investment of 3.4 times. That figure is impossible to ignore, and encourages many private equity firms to enter or stay in the market. They are also attracted by Japan s inefficient market for capital, which makes it easier to find value than in the US or EU. Will private equity one day fuel an even bigger wave of M&A activity in Japan, as many market observers have predicted for the past several years? It may, but that day appears to be a long way off. If it does arrive, it may not hold much reward for traditional, independent funds. Although the presence of private equity funds is starting to change the way deals are done in Japan there are more auctions and bids by consortia there are still many obstacles for traditional funds. Among them are competition from well-backed, well-connected domestic buyers attached to major financial institutions and others who can outbid private equity firms at auction; a lack of talent; a lingering resistance to the concept of handing substantial management control to outsiders; and a regulatory outlook that seems destined to discourage traditional private equity firms. The Economist Intelligence Unit

9 Private equity in Japan Fuelling the next M&A wave? Where did it come from? To imagine the future development of private equity in Japan it is useful to look at its brief history. The development of modern private equity is generally considered to have started less than ten years ago, when Advantage Partners launched its first fund in As the Internet bubble inflated, a number of venture capital companies also started up. Simultaneously, foreign-affiliated funds focusing on the market for distressed assets set up operations in Japan. Many of the first buyout funds were by necessity non-japanese, since regulations on so-called limited liability partnerships (LLPs), first introduced in 1998, prevented firms from investing in anything but small and medium-sized enterprises (SMEs) and from participating in the management of the firm in which they invested. More importantly, the tax code penalised such investors because returns to the partners were taxed as ordinary income rather than at the lower rate on capital gains. When the global economy sank into recession after the bursting of the Internet bubble, dragging Japan s economy down with it and threatening to ignite another financial crisis, the Japanese government made more reforms in the hope of increasing the supply of risk capital needed to revitalise its moribund corporate sector. Further revisions to the Limited Partnership Act for Venture Capital Investment in 2002 and 2003 liberalized investment methods and increased protection for investors. This led to a rapid increase in the number of limited liability partnerships and, as a result, an increase in capital flowing to unlisted SMEs. As late as 2004, however, the activities of LLPs were still narrowly circumscribed. As a result, firms hoping to invest in the rehabilitation of listed companies through takeover bids (TOBs), debt-equity swaps, mezzanine loans and so on were few and often incorporated offshore in tax havens like the Cayman Islands. In order to encourage the development of an on-shore (and domestic) private equity sector, a fourth set of revisions was made in 2004, allowing LLPs to invest in any company, not just unlisted SMEs. In addition to corporate revitalisation, the move was also, no doubt, intended to prevent the kind of enormous loss to the treasury that happened when US private equity firm Ripplewood relisted the resuscitated and renamed Long-term Credit Bank of Japan (now Shinsei Bank) in early 2004 and paid little tax in doing so. But the 20% Shinsei Tax on divestitures from majority holdings by financial buyers (which involved a widening of the tax net to include certain inbound investment structures) had not much more than a short-term drag on the industry. Private equity firms made their entry or re-entry into Japan, demonstrating that the perceived attractiveness of investments was much higher than the perceived regulatory and tax obstacles. At the same time that it was making staged deregulatory moves in favour of private equity firms, government-run financial institutions seeded the market with investments. The first and most significant among these was a commitment from the Development Bank of Japan (DBJ) in 2001 to invest 100bn in existing corporate revival funds such as Carlyle and MKS Partners, and new funds such as Phoenix Capital and Nippon Mirai capital. 8 The Economist Intelligence Unit 2006

10 Private equity in Japan Fuelling the next M&A wave? Growth of private equity Private equity involvement in the M&A market has risen spectacularly in recent years. Virtually non-existent as late as 1996, private equity firms are now a fixture at auctions for the cast-off subsidiaries of larger conglomerates, and increasingly an accepted (or at least tolerated) part of the business community. By early 2006 there were an estimated 100 private equity funds in Japan, with approximately 2trn ready for investment (up from 1.3trn in 74 funds in early 2005, which was double the year-earlier figure), according to the Nihon Keizai Shimbun (Nikkei), a Japanese economic newspaper. Although it still plays a small part in the overall M&A market in Japan, the sector shows no signs of slowing: the Centre for Asia Private Equity Research in Hong Kong estimates that Japan could attract up to US$8bn worth of private equity in 2006, up from US$4.7bn in It bases its forecast on activity to date this year, including the impending management buy-out of Skylark, a restaurant chain, which will be worth US$2.5bn. (Nomura Principal Finance and CVC Capital Partners, a private equity fund, have set up a special purpose vehicle for the MBO and plan to take a 66.67% stake in the company.) Contrary to the idea that the proliferation of private equity funds represents an influx of foreign money, most of these funds come from Japanese investors. According to an August 2004 survey by Nikkei, 88% of private equity capital comes from Japanese sources, including regional banks and local financial institutions and government banks such as the Development Bank of Japan. While the market has so far been driven from the supply side, there are signs that private equity funding is at least being considered by Japanese executives. In a Nikkei Business Daily survey of the presidents of 100 major companies in Japan in October 2005, 38.9% of the respondents said they would like to consider working with buyout funds when acquiring a company, depending on the cases and partners, while 4.6% said they were already working with buyout funds and 0.8% said they would like to actively consider working with them. In total, 44.3% of respondents had buyout funds in mind. The ratio jumps to more than 50% when it comes to respondents in information technology, electronics and material sectors. But it seems that Japanese managers are most willing to work with private equity funds when they want to buy 65.6% of all respondents said they expect to purchase firms whose businesses complement theirs. It remains to be seen who will be willing to sell. Perhaps even more than the regulatory changes, this government pump-priming meant to many domestic players that private equity was now an anointed industry. Almost all of Japan s major financial groups launched funds in 2002 and 2003, as did trading companies and other non-bank financial groupings. By 2004, this model was being replicated on the regional level. Seed capital from the Japan Small and Medium Enterprise Corporation (now the Organization for Small & Medium Enterprises and Regional Innovation) encouraged local governments to tie up with local banks to launch funds specialising in firms in their specific area. The expansion of the scope of legal activity for LLPs was certainly designed for more than just private equity activity. But in combination with the government s financial incentives for the sector, domestic private equity activity received an invaluable boost. Government policymakers thought, however, that they were promoting the growth of what they called corporate revival funds. The expectation was that these funds would primarily focus on purchasing a company s The Economist Intelligence Unit

11 Private equity in Japan Fuelling the next M&A wave? distressed loans and real estate, as well as the debt that had been converted into equity via a debt-equity swap. It was also expected that these funds would be set up by the major financial institutions and indeed many did establish funds to help them unload the bad debts they held (see below). But it was expected that such funds would do little more than become minority equity holders. Milestones Major investments/divestments by foreign buyout funds September 1999 September 2000 January 2001 April 2001 September 2001 May 2003 June 2003 August 2003 September 2003 May 2004 October 2004 November 2004 May 2005 October 2005 December 2005 December 2005 January 2006 June 2006 Source: Centre for Asia Private Equity Research Ripplewood Holdings (now RHJ International ) selected as sponsor for failed Long-Term Credit Bank of Japan (now Shinsei Bank) WL Ross took control of the Kofuku Bank (now known as Kansai Sawayaka Bank Ltd.) Lone Star selected as sponsor of failed Tokyo Sowa Bank (now Tokyo Star Bank) Lone Star establishes Pacific Golf Management (PGM) Carlyle Group leads a consortium of investors to take up a minority position in eaccess, then the largest deal in Japan s telecommunications industry WL Ross sells Kansai Sawayaka Bank Cerberus Capital Management takes control of Aozora Bank (formerly known as Nippon Credit Bank) following Softbank s sale of its holdings in the bank Ripplewood acquires Japan Telecom Carlyle Group agrees to purchase Colin Corp (now Colin Medical Technology, CMT) Ripplewood sells Japan Telecom to Softbank Carlyle takes control of DDI Pocket (now known as Willcom Inc) JP Morgan Partners Asia (now known as CCMP Capital Asia) sells Rhythm to Carlyle Group, the first secondary buyout transaction among foreign buyout funds in Japan Carlyle sells CMT to Omron Tokyo Star Bank goes public Cerberus Asia Capital Management buys assets from Seibu Group Pacific Gold Group International Holdings, holding company of PGM, goes public Goldman Sachs agrees to take control of Sanyo Electric CVC Asia Pacific participates in Skylark s management buyout, the largest in Japan 10 The Economist Intelligence Unit 2006

12 Strength in depth For further information please contact Naoki Kinami, managing partner James Lawden, managing partner Nobuo Nakata, partner Akihito Katayama, partner Julian Pritchard, partner Freshfields Bruckhaus Deringer Ark Mori Building 18F Akasaka Minato-ku Tokyo T F Freshfields Bruckhaus Deringer is a fully integrated law firm with over 2,500 lawyers in 28 offices in 18 countries. Our lawyers have an impressive depth of experience, both domestically and internationally. We have worked on some of the largest and most prestigious deals in recent years, bringing together multidisciplinary teams of specialists able to meet the demands of the most complex transactions. In Japan we advise domestic and international companies on Japanese, English and US law across a range of practice areas. Boasting eight partners, of whom five are Japanese bengoshi, and over 40 legal professionals, two-thirds of whom are Japanese bengoshi, we are proud of our commitment to Japan. Our credentials speak for themselves. corporate and commercial work is a core focus for Freshfields Bruckhaus Deringer The [Tokyo] office is certainly one of the most integrated of all the international law firms, and boasts first class domestic and international partners (Asia-Pacific Legal 500, 2005/2006) Top ranked Japan Corporate/M&A: foreign firms (Chambers Global 2006) Top ranked Corporate/M&A: international firms and joint ventures (Asia-Pacific Legal 500, 2005/2006) International law firm of the year (Asian Legal Business China Law Awards 2006)

13 Private equity in Japan Fuelling the next M&A wave? Everyone into the game The proliferation of government-inspired involvement in private equity, which in turn has inspired other non-traditional investors to enter the fray, is one reason for scepticism that private equity (at least the traditional kind) will take Japan s M&A market to the next level. Indeed, the mini boom in private equity investment in the past few years has for the most part been fuelled by funds tied to Japanese financial institutions, both national and regional in scale. Although foreign funds continue to set up in Japan, and a few more independent domestic funds have been launched, the increase in the number of funds has come primarily from spinoffs from domestic investment banks, regional banks, insurance companies and quasi-financial conglomerates such as trading companies and non-bank financial institutions. Most of these funds are tiny ( 10-50bn/ US$87m-435m) in comparison with large funds in the US, which raise US$10bn annually, and were set up by Japanese financial institutions. Some of them were launched in order to help clear up the non-performing loan portfolios of their parent bank. Synergy Capital, for example, was set up by UFJ, with participation from Orix, Marubeni Corp and Sojitz. The fund s senior executive officer, Hiroyuki Kataoka, says its 14bn fund was created specifically to purchase and turn around weak firms to which UFJ was the main lender. Synergy is not alone. Phoenix Capital (Bank of Tokyo-Mitsubishi), Vision Capital (Bank of Tokyo- Mitsubishi), and Mizuho Capital all fall into this category. Nomura has Nomura Principal Finance and Nikko has Nikko Principal Investments and Nikko Antfactory. Although these players started relatively late, their solid market coverage and networking ability make them formidable competitors. They source deals from their parent bank s network and, because of the close relationship between the bank and the firms, they often get deals on an exclusive basis rather than through auction. Mr Kataoka says that this is exactly how Synergy sourced the seven deals that it has done. Not all such players are intending to stay for the long term, however. Some of these funds are limited to doing deals only within their main bank network, and will eventually close. In the case of Synergy, the merger of UFJ into the Bank of Tokyo- Mitsubishi group, combined with a waning of the NPL problem, have left it without a raison d être. Synergy has exited completely from two of its acquisitions and is focusing on exiting from the rest. Mr Kataoka says the fund is not considering any new acquisitions, and has not decided whether it will raise a second fund or close once it has sold its remaining holdings. Other institutionally-backed funds are here to stay, however, given that the returns from private investments are so much higher than for other main-line financial services. Even Japan s plodding trust banks have gotten into the game. Focusing on owner-managed firms with succession problems, they offer to set up a trust account into which the owner passes the equity he or she owns. The bank then becomes the de facto owner, managing the company and paying dividends into the trust. The trust banks do not have managerial skills, of course, but this method of crystallizing the value of a company is attractive to some owners. Japan s trading companies and the investment arms of conglomerates such as Softbank (which 12 The Economist Intelligence Unit 2006

14 Private equity in Japan Fuelling the next M&A wave? Pausing or declining? Fund raising for Japan Amount raised, US$ bn Source: Centre for Asia Private Equity Research Number of funds raising new money focuses on IT and Internet-related businesses), Orix and Nisshin (non-bank financial services) are also extremely active financial buyers of companies. Although these are not technically private equity firms since they are tied to listed companies with mainline businesses, they act like private equity firms, taking a financial stake in companies and using their managerial capabilities and synergies with other existing businesses to realize value in their investments. They are very active in the market, and they are very competitive bidders. Because they are earning returns for public shareholders rather than private investors, their internal hurdle rates are lower, so they can potentially outbid private equity firms at auction. The result of all of this activity, as noted by Yasushi Hatakeyama, president and CEO of Lazard Frères Japan, is that a slew of financial buyers are competing in what is still a relatively small and unsophisticated market. When private equity activity got under way in the late 1990s, there were limited players and most had a sophisticated approach, he says. There were also a lot of targets due to the non-performing loan (NPL) problem. Today, the NPLs have been cleaned up and there are many newcomers. Competition is fierce and somewhat irrational. In the rush to put their capital to work, many private equity firms are abandoning their original mandates. Firms ostensibly running buyout funds are also taking minority stakes, investing in technology companies like venture capital firms, or moving into real estate investment. In fact, there is considerable anecdotal evidence in the market that many of the private equity players are doing deals for the sake of doing deals rather than for good returns. Many of these funds are ending up with weak portfolios that they will have difficulty exiting from at a decent return. At the same time, they are driving up prices (and driving down profits) for other players in the market. For example, when Dai-ichi Sankyo decided in early 2006 to sell babyfood manufacturer Wakodo through auction, overbidding by private equity firms caused the eventual buyer, Asahi Breweries, to pay a 150% premium to Wakodo s share price for a firm in a business in which the number of consumers (babies) seems to be in irreversible decline in Japan. This was not an isolated incident. The Centre for Asia Private Equity Research calculates that the internal rate of return for private equity ranged from -39% to 66% in 2005, down significantly from the 32% to 230% rate of return in 2004 (this rate is calculated on realized exits; since fund houses rarely disclose negative returns, the figure has an upward bias). Competition driving acquisition prices higher is surely one reason for the lower returns. It is worth noting, however, that since most funds in Japan are tiny, competition for large deals is much less intense, although this could change with the entry of more large foreign fund houses. Not all the players are worried about these trends. Guido Gamucci, chairman of Permira in Japan, who worked in Europe throughout the evolutionary phase of the market, says that institutional players have a significant role in The Economist Intelligence Unit

15 Private equity in Japan Fuelling the next M&A wave? Interview with Sir Deryck Maughan, managing director and chairman of KKR Asia EIU: What was the trigger for KKR s decision to invest in Japan now? What is different in the Japanese market today compared to several years ago? DM: In the 1990s Japan was a very large distressed market, but KKR is not a distressed investor. With the recovery of the Japanese economy, with the slow opening of China, with the development of investment opportunities and acceptance of private equity throughout Asia, KKR decided early last year to make a commitment to the region. Japan is of course the key market in the region. It is exciting to be here. We don t know what the outcomes will be. Japan is changing, private equity will become part of its capital structure, and KKR is well qualified to provide solutions to Japanese companies. EIU: The distinction between "distressed" and "buy-out" does not seem to be very clear in the Japanese market. Do you see that changing? DM: Much of corporate Japan is uninformed about what private equity is and what the differences are between a growth investor, a distressed investor, a hedge fund, a greenmailer etc. All of us who are interested in developing a significant long-term business in this market have a responsibility to explain these differences and then live by what we say. EIU: As the economy recovers do you think that Japanese companies will be less willing to put a piece of their business on the block? DM: There is very little evidence of the large buy-out or the large corporate partnership today. The market in my view is very much in its early stages of development. Some may predict that it s never going to happen but I think that you will see over the next year or two some quite important investments take place in this market, both with domestic companies and with Japanese companies seeking to invest overseas. EIU: What will cause the perception of private equity to change in Japan? DM: In a word, it is something called trust. I think Japan fully understands the nature of global competition, the need to invest in their businesses and to improve profitability. Japanese companies have learned a lot from the past decade. A significant amount of restructuring has already taken place. The people who say Japan cannot change are the ones who do not come here. Japan is conscious of the rise of China, of the competition it faces from the US and others, and it views as a matter of national interest the need to maintain the competitiveness of its industrial sector. For example, there is still considerable work to do in financial institutions; there is work to do in the technology sector. There are other sectors that are exposed to global competition where the return on capital needs to be raised. The question is whether we can be culturally adept, whether we can deliver our capital and experience in a way that can be accepted and used by Japanese companies. So I say it is about trust, not about price earnings multiples, EBITDA, cash flow or anything like that. EIU: Japanese firms are more comfortable with M&A today, but mainly in order to purchase an asset. There is a fear that they are still unwilling to sell. And even if they do, why would they sell to a private equity firm? DM: Well, we re not in Kansas anymore. Japan is a stakeholder society as opposed to a shareholder society. Shareholders are important but they are not the only, or even the paramount, constituency. It s the American model that is unique. Germany and France, for example, are also stakeholder societies. Japanese firms are reluctant to pass their businesses to other companies because of the responsibilities they feel, and the competition between the keiretsu is evident and longstanding. It would be easier for a Japanese company to invite in a neutral investor such as a private equity firm rather than sell to a competitor. Those who insist that we are going to do it the American way will die of frustration. There is no one size that fits all. At the same time, being culturally adaptable does not mean sacrificing ones principles, analytical methods, or the investment returns required. It is going to take time, but I believe that one of the leading companies in Japan will accept a private equity firm as a partner in the improvement of a noncore business or as a partner in a strategic acquisition overseas. 14 The Economist Intelligence Unit 2006

16 Private equity in Japan Fuelling the next M&A wave? EIU: What lessons did you learn in Europe and how will you repeat that in Japan? DM: What made the difference were the people that we hired in this business, it's all about talent. And there was also an evolution in KKR s methodology in dealing with German corporate structures. We worked with supervisory boards, labour unions and others. Finally, it was the value we added after the deal was signed. Some people may characterize us as a financial investor, but the essence of the current stage of our business is the operating experience we bring to bear. Compared to 15 years ago, there has been a significant shift in KKR s partnership towards people who never worked on Wall Street but did run real companies. We have our own internal consulting group. The average investment period for us is seven years, not seven days. The price the financial part of this comes at the end. People are beginning to understand that and the dialogue is beginning. The breakthrough for us in Germany came when a blue-chip company put its trust in us. And one good thing led to another. People felt comfortable, they could point to examples. The same will be true here. It will take a while to get the first deal and then the others will follow. But our philosophy is the opposite of the idea of buy em cheap and break em up. We view capital as a commodity. These days everyone has an LBO model on their PC. Any fool can buy a company if you pay enough; it s what you do after you buy the company that is important. EIU: Talent seems to be one of the key bottlenecks regarding the post-purchase turnaround in Japan. How do you plan to overcome it? DM: The lack of talent is indeed a major problem. It is the critical factor in the success of any company wishing to establish itself here. The talent pool is relatively small and the demand is very high. We would rather be patient about the team we put together than pile on some numbers. KKR globally only has 75 professionals. We need a few highly qualified people in Japan and we will take our time to find them. And it will take time. Ultimately there will only be three or four great teams in Japan, not 20. We want to make sure we are in that group. EIU: In the meantime, are you worried that the domestic institutional players may sew up the market or create a reputation for private equity that makes it difficult for firms like KKR to educate the market and achieve its goals? DM: No. I don t think a Japanese bank can create a large subsidiary that does what we do. It hasn t been done in other countries. It is a special kind of life form. But the major Japanese banks will be our partners, who can discuss with us privately the challenges and opportunities companies face and may be co-investors in the deals. We ve had a relationship stretching back more than 20 years they ve been important investors in our previous funds and funders of our transactions in New York and London. So I m confident they will stand behind us when we make our first investments here. the early years of the development of any market, but with time they tend to lose momentum. Their initial strength, represented by ample market coverage and sourcing opportunities, is weakened by emerging conflicts of interest and loss of talent to independent start-ups. Only the real independent private equity firms are successful in the long run, he says. It remains to be seen whether this pattern will hold in Japan as well. A major difference between Japan and more developed markets is the state of its banks. While more market sensitive than they used to be, Japanese banks are not under nearly as much pressure from shareholders to maximize profits as their US and European counterparts. And with returns in mainline financial services so low, even doing a private equity deal poorly will probably return enough to make it worthwhile. This situation is likely to persist as the postal savings system is privatised, unleashing even more money to search for higher returns in the Japanese economy. The Economist Intelligence Unit

17 Private equity in Japan Fuelling the next M&A wave? Finally, even if the returns are sub-par, there is business logic to staying in the game. Doing deals means the biggest private equity players end up with a smaller deal flow and lower profits, preventing them from gaining traction and influence in the market the kind of zero-sum approach to competition that is very common in Japan. The institutional players may eventually drop out of the running, but given the state of financial returns in Japan s market, this may take a surprisingly long time. 16 The Economist Intelligence Unit 2006

18 Private equity in Japan Fuelling the next M&A wave? Finding the inside track Another obstacle to traditional private equity players one that is compounded by the intense competition is the difficulty of sourcing deals in corporately conservative, relationship-centric Japan. Only a few years ago the private equity business was much easier, not only because there were fewer firms in the market, but also because there were plenty of investment opportunities that were open to all who were brave enough to take them. The banks non-performing loan (NPL) problem created a lot of low-hanging fruit firms with stable core businesses but weak balance sheets that needed the kind of financial re-engineering that private equity firms do best. Some argue that there is still plenty of lowhanging fruit (see below). But regardless of the height of the fruit, it is deal sourcing that is the lifeblood of the private equity business. According to Mr Hatakeyama of Lazard, private equity firms succeed by developing a proprietary deal flow. In the US this is possible because business managers are strategic sellers, and often seek out private equity firms as counterparties. In Japan, the thought of a firm selling a core business that no longer earns sufficient returns, as IBM recently did with its PC business, is still difficult to accept. Moreover, a Japanese seller is unlikely to turn to a private equity firm as a counterparty based on the fund s brand and reputation. Just because you are an influential global private equity firm doesn t mean people will bring deals to you in Japan, says Mr Hatakeyama. You have to demonstrate unique added value. Name value does not do much for Japanese managers. He is partially correct: a foreign private equity firm s brand does not have much value in Japan. But if the firm recruits brand-name Japanese executives as advisors, Japanese industry will take notice. This is exactly how Ripplewood, a US private equity fund renowned for its turnaround of the Long-term Credit Bank (now Shinsei), has built its successful franchise in Japan (see box), though firms such as Ripplewood are also appreciated for being able to provide a lot of money quickly. Only the biggest and best-paying private equity firms are likely to build a network like Ripplewood s in order to source deals. Lesser firms have it much harder. One innovative way they have developed to get in the door of potential sellers is to tie up with an industrial company, marrying the business contacts of the industrial firm with the financial skills of the private equity firm. For example, Japan Private Equity has allied with Sanyo Electric Capital to acquire spinoffs in the electronics sector. Nippon Venture Capital has tied up with Opt Inc, an Internet advertising agency, to create a 3bn fund. Opt is primarily responsible for finding target ventures, aiming at firms in the Internet and mobile phone sectors with which it believes it could produce synergy. It will also provide business-planning and financial advice to these companies. The US investment firm ZenShin Capital Partners has joined forces with Aeria, which provides online game content, to set up a 1bn fund in the IT industry. For mid-market firms that want to remain independent, however, the task of competing to source deals is more daunting. Independent funds often approach investment banks to source ideas and contacts, but success will only come if they create their own proprietary deal flow. For that to happen, they must give sellers a reason to choose them over other firms. According to Nick Benes, president of JTP, an independent financial The Economist Intelligence Unit

19 Private equity in Japan Fuelling the next M&A wave? consultancy that advises on M&A transactions, this could be a track record of success and of adding value beyond financial engineering, access to good managers and post-acquisition strategies, or a reputation of being an advisor on the side of management. Money is not enough, he says, because there is plenty of it floating around Japan. Some private equity firms in Japan have built up such a reputation. Synergy s Mr Kataoka points to the first movers like Advantage, Unison, and MKS, whose track record of success has bred market recognition, allowing them to raise funds and hire capable staff. Iain Drayton, director of investment banking at Nikko Citigroup, agrees, noting that in the early days of any developing market like Japan first mover advantage is important. Success begets success, and dominant firms soon emerge. Latecomers can still compete, but only if they set themselves apart from the pack by paying more or adding more value. In a market that has more money than talent at its disposal, the former is much easier than the latter. Adding value requires bringing something to the table that other firms do not have, such as a network or special expertise in a specific industry, access to new (or overseas) markets, skill at structuring and executing a deal, or access to experienced management to take over the acquired firm. According to Permira s Mr Gamucci, even these are no longer enough to differentiate one private equity fund from another. "Nowadays, you need to spot strategic and operational improvements and be Deal sourcing 101: The case of Ripplewood s advisors Deal sourcing is the lifeblood of private equity firms. In Japan especially, sourcing depends on a good network and this is the hardest par t of the business to build. One of the most admired networks in Japan belongs to Ripplewood, an American private equity firm renowned for its revamping of Long-term Credit Bank of Japan. Among its contacts: Hironori Aihara, former board member of Mitsubishi Corp and currently a board member or auditor of seven Japanese companies, an advisor to the Japan Highway Public Corp as well as to several METI councils and the Cabinet Office ; Toyoo Gyohten, former chairman of the Bank of Tokyo, a former high official in the Ministry of Finance; Ernest Higa, CEO of Higa Industries, whose family members run Ebay Japan and KFC Japan; Yoichiro Iwama, managing director of Tokyo Marine & Nichido Fire Insurance and a board member of Aozora Bank; Tetsuro Kawakami, senior advisor to Sumitomo Electric and a member of the board of the non-profit organization Prop Station, on which also sit many city mayors and prefectural governors; Yotaro Kobayashi, chairman of Fuji Xerox and past president of the Keizai Doyukai business association; Minoru Makihara, former chairman of Mitsubishi Corp, senior advisor to the Ministry of Finance and advisory board member to Coca-Cola, Allianz, JP Morgan Chase, the NYSE and Daimler-Chrysler; Yukio Noguchi, professor of economics and former Ministry of Finance official; Tatsuya Tamura, former chairman of AT Kearney Japan, former official at the Bank of Japan and currently a board member of Orix, Suruga Bank, Kanebo Cosmetics and SkyPerfect Communications; Goro Watanabe, senior executive of Mori Building and former CEO of Mitsui Chemicals; Masamoto Yashiro, chairman of Shinsei Bank and formerly CEO of Exxon Japan and Citibank Japan; and S e i i c h i r o Yo n e k u r a, p r o f e s s o r o f business at Hitotsubashi University and government advisor. Source: SUCCESS STORIES JAPAN Executive Newsletter, May 2006 issue 18 The Economist Intelligence Unit 2006

20 Private equity in Japan Fuelling the next M&A wave? able to attract or motivate top management talent to implement value-creating strategies," he says. Mark Ferris, a partner at a small Japan-based private equity firm called Building2, which currently has 11 companies in its portfolio, says this is how his firm built its franchise. The managers of the fund had previously set up, run, and then sold a successful business in Japan, which gave them credibility. But even the best private equity firms find it difficult to add the kind of value that a strategic buyer can. Mr Benes of JTP says most private equity funds add value by providing much-needed liquidity and doing so faster than a strategic buyer could. They may restructure cash management, collect receivables more quickly, and cut costs here and there. However, they are rarely capable of true strategic change such as new product development or large directional changes. At best, he says, most private equity funds give the management of the acquired firm independence from an uncreative board of directors that allows them to sell or write off a loss-making business line. Going beyond that is never easy in any market, but that is especially true in Japan for one simple reason: there are not enough experienced turnaround specialists in the private equity market. Indeed, Michael Korver, professor at the Hitotsubashi University Graduate School of International Corporate Strategy, says that a lack of experience is the biggest limiting factor for private equity in Japan there are not yet enough opportunities for firms to learn by doing. Even the best foreign firms have found it difficult to build a team. Carlyle, for example, is considered to have one of the strongest teams in Tokyo, but it went through many managers and took seven years to put it together. Some market watchers predict that dealsourcing will become even tougher. Since private equity has been associated with the acquisition of distressed assets, it is fashionable to claim that Japan s economic recovery means there will be less opportunity for private equity going forward. With the Tokyo stock exchange near six-year highs and an improving economy shrinking the number of firms requiring a capital infusion or that are otherwise distressed, it might seem that the number of acquisition targets is dwindling. That is not entirely true. An analysis by the Nikkei Kin yu Shimbun (Nikkei Financial Daily) in early 2006 showed that there were still 68 firms with more cash on their balance sheets than the amount of money needed to buy half of their outstanding shares. Nevertheless, it is true that distressed assets are becoming harder to find. That will force private equity firms to compete harder and work smarter. Shuhei Abe, president and CEO of Sparx Asset Management, is one investor who believes there are still plenty of investment opportunities out there if you know where to look. His firm does not do private equity-like investments, but takes minority stakes in firms with an eye to influencing management. He disagrees with the idea that resurgence in the economy and stock market means there will be fewer M&A opportunities. Ultimately, this means that to find deals one must understand the industries, study the firms and, most importantly, know the management. He acknowledges that some managers might become complacent as the economy improves, but others who could not make changes before may now have the financial breathing space to do so. Those are the firms worth investing in, he says. There is simply no substitute for this kind of knowledge. But developing good intelligence is only a start. Managers reluctance to sell anything other than a distressed business to a financial buyer remains a key obstacle to the growth of private equity. The Economist Intelligence Unit