Toshiba's memory chip business, sold off for 2 trillion yen ($18 billion), by the debt-laden group to a consortium led by Bain Capital, has joined Japan's growing list of private equity mega deals.
The increasing flow of transactions means that few eyebrows are raised today when blue-chip Japanese companies carve out businesses and sell to foreign financial investors.
Kravis Kohlberg and Roberts (KKR) started the late surge of large deals in 2016 by announcing the acquisition of auto parts manufacturer Calsonic Kansei from Nissan Motor for 500 billion yen. Last year saw KKR purchasing two companies carved out from Hitachi, the electrical combine -- Hitachi Kokusai Electric and Hitachi Koki. Bain Capital followed suit by gaining control of Japanese advertising agency Asatsu-DK and then trumping all comers with the Toshiba Memory deal.
While these deals exceeding 100 billion yen in transaction size are well-documented, they are the tip of the iceberg. A.T. Kearney has analyzed data from Recof, an M&A advisory firm, on out-in (foreign funds acquiring domestic companies) private equity (PE) deals for which transaction values were available. We found that in the five years 2013-2017 there were 10 such transactions of over 100 billion yen and 38 priced at 10 billion to 100 billion yen. But there were no fewer than 146 transactions of under 10 billion yen. Value-wise, the aggregated transaction size of Out-In deals first surpassed that of In-In (domestic funds acquiring domestic companies) deals in 2013 and have continued to do so at least till 2017.
Why this rush of out-in deals? Firstly, with $2.5 trillion asset under management, global private equity funds keep attracting money from institutional investors hungry for enhanced returns. They have an insatiable thirst for sourcing deals. Japan has gained in popularity in the last three years as a stable and mature investment environment just when China, an established hot-spot, has faded somewhat amid concerns about the risks involved in increasing government economic control.
Moreover, once investors get over the mental barrier of viewing Japan as an aging sunset country with high entry costs, there is a growing recognition that it has much to offer. The opportunities for finding deals are multi-channeled, ranging from large enterprise carve-outs to mid-sized family-owned companies' succession challenges. On the management side, there is less embarrassment than in the past to selling out to financial investors. Successful turn-around cases under new owners, such as Sharp under Hon Hai Precision Industry, or Foxconn, coupled with the buoyant labor market eases the perception of outside investors being ruthless cost cutters only interested in slashing headcount.
Meanwhile, the Japanese government encouraged companies' restructuring efforts by expanding tax incentives for spin-off in 2017 to relax the tax burden associated with selling a business.
Finally, there is a growing talent pool in Japan to run the newly-acquired entities as hired guns -- seasoned industry executives who would normally expect their paycheck to shrink after the age 60 and mid-career managers with the pedigree and entrepreneurial mindset are less afraid to leave their current employers. Underlying this is the long-term trend of Japanese labor market. Private and public sectors alike consider moving the mandatory retirement age from 60 to 65 in lockstep with the prolonged life expectancy. Starting around 2000, many Japanese companies have adopted meritocracy-based promotion over traditional seniority-based. Combined, it means that life time employment increasingly loses its allure for workers. In fact, a recent Nikkei survey finds that a mere 14% of new hires fresh out of school intend to stay with the first employer until retirement.
But there is one big fly in the Japanese ointment for PE investors -- the time taken to implement post-deal corporate plans. From our work in due diligence and in post-merger support on behalf of buyers, we see that unlocking of potential can take longer in Japan.
Now, speed is critical for PE funds, which typically want to cash out in three to five years. Even if the original investment thesis is correct, if it takes too long to carry out the investors to the PE funds get frustrated. There are only so many times that you can sell a dream.
There is a reason why execution takes longer in Japan. While a typical private equity fund approach to unlocking value in North America and Europe is usually based on serious cost-cutting, this is less true in Japan. Prolonged labor shortages mean staffing levels are already lean. Where they are not, the law and social norms make large-scale lay-offs very difficult.
The Anglo-Saxon approach of short-term profit worship does not fly in Japanese culture. The lever to unlock value in Japan therefore often lies in promoting growth. While growth is more positive an ambition than cost-cutting, it also is more time-consuming to achieve. The only way for the private equity funds to avoid this trap is with a thorough assessment of the investment thesis.
Consider international expansion, which is a typical growth lever that a global private equity fund may propose. It is a well-told story that Japan, like Germany, has many so called "hidden champions," the low-key companies with manufacturing skills, niche product strengths and dominant market shares, which are all but unknown to the rest of the world.
These mid-cap companies, often producing components and other intermediate products, can be targets for private equity funds which might consider expanding their business abroad. While this is a sound hypothesis, a few pieces need to be in place before investors are assured of the right return within their chosen timeframe. Dazzled as they may be by the aura of the hidden champion, they need a reality check.
The first point to examine is the commercial viability of the product strength in overseas markets. Even if the quality is superior to rival foreign goods, it could be over-spec for foreign customers especially in developing markets. For the developed markets, the perceived quality of the offering may have less to do with the product itself but with other attributes such a short lead-time, that plays in the home market. A short lead time will not be a strength outside Japan without a foreign manufacturing base.
Second is the sales and marketing channel. If the target company has only a limited presence overseas, the investors need to plan how to quickly establish a foreign base, either through local distributors, green field investment or additional acquisitions. Moreover, often the Japanese domestic sales force sales may be so attuned to working locally that it cannot easily function overseas. New sales managers may need to be quickly hired and developed.
Finally, managers and staff at the acquired company must be motivated to attain the demanding new growth goals. In the case of a carve-out, there is often a pent-up frustration at the company that it was held back from achieving its full potential by the group. For example, a subsidiary of a large Japanese conglomerate may not have been encouraged to sell outside the group or to favor other group companies with generous pricing at the expense of stand-alone profitability. Extracting such a business from a bigger group can be a source of momentum for growth under the new shareholder.
But in other cases, pushing through the mindset changes required to boost top-line growth in line with PE fund's typical timeframe may prove challenging. This is especially true to transforming a company that was largely a domestic operator into a global business.
KKR announced in 2017 that it would earmark 300 billion yen for Japan out of a 1 trillion yen Asia fund, their largest allocated to the region to date. As the proverb goes, appetite comes with eating. Global private equity funds have just begun their feast in Japan. The growth-oriented approach could work well for all stakeholders, creating global companies, securing old jobs and creating new ones. But the investors will only retain their taste for things Japanese if they realize their investment thesis. The early stages are critical.
Nobuko Kobayashi is a partner with A.T. Kearney, a global management consulting firm, based in Tokyo. She specializes in the consumer sector with a special focus on multi-national corporations operating in Japan.