It is extraordinary that after two decades of buy-out frenzy in the US and Europe it is only recently that international investment banks are opening up leveraged finance operations in Japan. Can the Japanese market emulate the US and Europe? Not yet, but there are some multi-billion dollar bets going on that it soon will.
Carlyle Japan Partners managing director Masato Marumo is a man who clearly enjoys the challenges of his work, someone familiar with the adage no pain, no gain.
At the cutting edge of Japans nascent leveraged buy-out market since its inception, he recalls the $2.1bn buy-out of mobile phone maker DDI Pocket, now Willcom, in October 2004 with a mixture of pride and pain.
He remembers how tough it was to deal with the six local and international banks that eventually formed the senior loan syndicate. Jokingly, he refers to them as a "six headed dragon" and recalls some extremely tough negotiations.
As the Tokyo rumour mill suggests, Willcom should soon launch an estimated ¥500bn IPO, and the deal is likely to reap Carlyle and co-investor Kyocera Corp a handsome reward. Newspapers at the time of the buy-out reported their equity commitment was less than ¥40bn.
Financial returns aside, Marumo says the deal was pivotal in the Tokyo lender community with Carlyle achieving a breakthrough in mutual understanding and respect. Carlyles subsequent LBO successes have not all been plain sailing, but the waters are clearly less stormy than before.
Good news, bad news
According to some reports, private equity funds committed in Japan during the 1980s totaled less than $100m, while in the US in the same period the figure was at least $50bn.
Although the Japanese mergers and acquisitions market has grown quickly in recent years, leveraged deals accounted for less than 3% of the market volume in 2005 and 2006, whereas the figure in the vast US M&A market has consistently been over 20%, at least until the recent credit market turmoil.
That is both good news and bad news. Good news because where the US financial markets lead, the rest of the developed world usually follows. Bad news because while there is already a very big pot of money in Japan wanting to join the leveraged buy-out game, the elite of Japans corporate and investment community are reluctant to play ball.
Jiro Seguchi, head of Japan origination at Merrill Lynch Japan Securities in Tokyo, has no doubt that the LBO glass is half full.
"Will M&A continue to grow in Japan?" he questions. "Yes, we believe it should. Will sponsor-driven activity as a percentage of the total M&A pie grow? Again, yes although with the caveat that the progress might not be initially as rapid as might have been hoped for. We need to be patient as financial sponsors become better understood and ultimately win more deals in the M&A arena in Japan."
Certainly the number and the value of MBO transactions in Japan has been on the rise for some years. There have been plenty of headline-making deals. The ¥223bn buy-out and de-listing of clothing company World Co was Japans largest private deal when it was concluded in September 2005.
Other landmark deals of that type include the MBO of beverage company Pokka Corporation, also in the autumn of 2005, a deal initiated by the companys founders and management. And, at ¥256bn, the current MBO record-holder, the completion of the buy-out and de-listing of restaurant chain Skylark took place in 2006.
The most high profile LBOs of subsidiaries and divisions of larger companies include the Willcom deal of late 2004, the purchase of the formerly listed Toshiba Ceramics, a ceramics and wafers maker, from Toshiba Corp for about $1.2bn, and the $500m buy-out of MEI Conlux from private US foods giant Mars Inc in 2006.
LBO market not punching its weight
But despite these highlight deals and numerous smaller buy-outs across the length and breadth of Japan, the LBO market is an under-achiever. Many market participants argue that while there is big potential, the market is dragging its feet, held back partly by a misperception among Japanese corporate management and the public at large that private equity firms exist mainly in order to take from their collective rice bowl.
While there remains a shortage of deals, the demand side of the LBO and leveraged finance equation has only positives to date.
Seguchi, working on back-of-the-envelope calculations, estimates there is at least $20bn of financial sponsor money dedicated purely to Japan already, and with global private equity money that might also find its way to Japan, total funds available in Japan could amount to $30bn or more.
Whereas the market started out with tiny home-grown funds from 1997 onwards, the size of new Japan or Asia-wide funds is rising up to $2bn in some cases.
And with equity typically representing only about 20%-40% of the total funding of LBOs, it is clear that the market needs a much larger dealflow to satiate sponsors appetites.
"Assuming only modest leverage of about three times or so, that implies about $100bn of deal capacity in Japan," Seguchi says. "However, we estimate that actual LBO/MBO transactions are running annually at less than 10% of that capacity. The result of course is tough competition for deals and a tough market."
And on the leverage side, there is more than enough senior debt and ever more mezzanine finance providers. Far from a shortage, there is excess cash and not enough homes for it.
A case of mistaken identity
One factor holding back the LBO market is that the private equity industry is new in Japan and there is a lot of misunderstanding among corporate management and the public. "Until the corporate world and the public at large stop confusing us with activist shareholders, hedge funds or other little understood investors we will all probably not succeed as we should," Carlye's Marumo says.
The widespread misperception has been fuelled by a spate of high profile, domestically originated hostile bids, all of which have failed amid considerable acrimony.
Internet services company Livedoors hostile and parried attempt to wrest control of Nippon Broadcasting System was one such high profile endeavour, which also peripherally involved the activist shareholder fund, the Murakami Fund.
In March this year, Takafumi Horie, Livedoors 34 year old founder and former president, and some of the Livedoor management were handed jail terms (some suspended) by the Tokyo District Court, which in July also sentenced Yoshiaki Murakami, founder of the Murakami Fund, to two years imprisonment without suspension and imposed hefty fines for insider stock trading in 2004 and 2005.
The problem for many casual observers from Japanese companies, and shareholders, is that they find it difficult to distinguish between these sort of notorious mavericks and the professional private equity investors who are not only intent on gain, but also on value creation for the broad base of constituents of the companies they end up controlling.
The waters have been further muddied by the high profile activities of overseas funds such as US fund Steel Partners, which appear to see themselves both as private equity funds and also activist shareholders championing the cause of transparency and corporate governance.
In one such instance of persistent shareholder activism, which many in Japan see as bordering on harassment, Steel Partners has so far failed to impose its will on Bull-Dog Sauce Co. Steel this summer had its case thrown out; the case was designed to stop Bull-Dog from issuing warrants to shareholders other than Steel in order to dilute the US firms stake.
Entities such as Steel Partners, even though they might not have wanted to, have added to the confusion and fear in the boardrooms of mainstream corporate Japan, with many such boards feeling increasingly vulnerable.
Kazuaki Kitabatake, managing director and joint head of investment banking group II at Mizuho Securities in Tokyo, is experienced in leveraged finance in both the US and in Japan he recently moved from Mizuho Corporate Bank and he has a crystal clear perspective on the Japanese market.
"To the average Japanese eye," he says, "it is perhaps difficult to distinguish between these types of investors and the more benign and management friendly LBO funds."
And Carlyles Marumo adds: "Many people here all too easily lump the private equity firms, hedge funds and global activist funds together almost as a secret society."
Little surprise therefore that the Nikkei newspaper reported that in June, 210 companies sought approval for numerous different poison pill takeover defences, nearly 10% of firms holding general shareholder meetings that month. Just as in the case of Bull-Dog Co, the shareholders invariably and perhaps often erroneously supported those incumbent management teams.
Another, closely associated problem is the return of cross-shareholdings, which in their former keiretsu guise declined substantially in the years after Japans 1998 financial crisis.
These are again on the rise, Kitabatake notes, as management teams seek the support of big trading companies and their big corporate customers to defend themselves against actual or potential takeover attempts, or at least efforts to influence management.
During and after last years hostile but failed takeover attempt of Hokuetsu Paper Mills by Oji Paper, corporate ownership on Hokuetsus register leapt from about 15% in fiscal 2005 to above 45% as the company issued new shares to Mitsubishi Corp and Daio Paper Corp as part of its defence plan.
Another defence mechanism, albeit a more positive manifestation in the form of active use of cash and boosting earnings per share, is that many listed companies have been buying back and retiring their stock.
Tokyo Stock Exchange figures show that share buybacks plus dividend payments totaled a record ¥13tr last fiscal year ending March 31, with about ¥2.7tr of stock retired from issue.
That is encouraging, although much progress is needed before corporate Japan passes back more of its vast cashflows and cash reserves to shareholders. The figure is, by comparison, much less than the nearly $80tr that S&P 500 US companies returned to shareholders in 2006.
Rex highlights potential conflicts
Moreover, one landmark privatisation buy-out and de-listing late in 2006, the buy-out of restaurant chain Rex Holdings, has had to face legal questions that highlight an important debate on potential conflicts of interest when boards of directors seek to buy out the company they represent [see the leveraged buy-out deals chapter on p40].
There is potentially a natural conflict of interest when a companys management is seeking to buy it from shareholders. "Sentiment," Kitabatake observes, "has not been helped by some minority shareholders having taken the legal route to try to claim that the prices paid for some MBOs are unfair, artificially low due to the greed of the management teams willing to sell out to the private equity firms."
"However," says one senior banker who wished to remain anonymous, "the flip side is that there is an equal and opposite conflict if management are seeking to protect their own positions and ignore and possibly denigrate valid bona fide third party offers to buy the company. We have seen that regularly in recent years, frequently resulting in offers at large premiums being rejected without any properly articulated economic or strategic justification."
Obtaining a seat at the table
Partly because of the conservatism rife in the boardrooms of Japanese corporations, and partly because financial sponsors and their buy-out structures remain poorly understood, private equity firms have found it tough to get a seat at the table when Japanese companies seek to sell businesses.
"The underlying problem is a cultural reluctance among Japanese owners and management to have external parties look through the books and also to invite external capital," says a banker in the loan business department in fixed income at Nikko Citigroup. Noting that there is plenty of money available to fund M&A in all guises, he adds that "the problem in Japan is on the supply side, not on the demand side".
Another problem is that strategic corporate buyers in Japan are beating the private equity funds to the deals, partly because of a preference among sellers for mainstream buyers, and partly because they are paying higher prices.
"In the current environment of high economic and corporate confidence, aligned with a strong stock market, prices of businesses are up," says Koji Sasayama, managing partner of M&A advisory firm Mezzanine Corporation. "We have also seen some senior lenders to planned LBOs become slightly more cautious, wary perhaps of private equity buyers trying to push out the envelope of Ebitda multiples and the terms they want to extract from the banks."
Mezzanine Corporation was established in October 2005 as a wholly owned subsidiary of GCA, Japans biggest M&A advisory firm.
Cash rich, acquisitive, sentimental
Mizuho Securities Kitabatake argues that LBO funds are at a disadvantage because of the keen appetite among companies for new acquisitions. "Corporate Japan suffers a low yield and low distribution to shareholders, which make it easier for Japanese companies to pay high prices and to justify those valuations by theoretical synergies of product, geography and customer base."
He also notes that in Japan, corporate acquirers are at an advantage because of the cultural reluctance among target companies management teams to countenance a non-strategic partner or investor. "Many of the senior members of such teams are nearing the ends of their careers," he says. "Why would they want to take huge risk or do anything out of the ordinary, when they have not for all of their working lives?"
Moreover, experts observe that sellers are cautious as well. The companies disposing of their subsidiaries or divisions often also prefer a corporate buyer because they feel liable for these entities and their employees after the disposal, and want to leave them in good hands.
"They feel less comfortable if their disposal has been to a financial sponsor that is leveraging the target assets, rather than to a corporate strategic buyer," explains Kitabatake. "Hence, sometimes they only pay lip service to financial buyers and often, if terms are similar, the corporate will generally win the day."
The result is that the LBO financing market is already nearly 10 years old in Japan, but with senior funding of about $5bn each year and mezzanine of about $1bn last year, it remains remarkably small compared with its potential.
However, Sasayama notes that the momentum is positive and a glance back at the history of the US LBO market, which started in the 1970s, shows that some patience is required before potential is fulfilled.
"Private equity," he contends, "has most definitely moved from a second class citizen as recently as one or two years ago and LBO funds are now invited to almost every controlled auction."
The $534m buy-out of MEI Conlux from Mars Inc in June last year is an example of an opportunity afforded by a foreign seller that was also sensitive to supporting the incumbent management.
Typically in the US a disposal of this size and nature might have been conducted as a pure auction. However, as a private company that was selling a business only a few years after buying it, Marss management apparently did not want to open the deal to all and sundry.Hence what appears to have been a controlled sale to a small group of exclusively financial sponsor bidders, with Advantage Partners and Bain Capital winning the mandate [see the leveraged buy-out deals chapter on p37].
Merrills Seguchi believes that private equity funds might need to diversify their tactics, perhaps to include corporate partners in their acquisition attempts. "Pure control-taking purchases are tough to locate, and it is difficult for the financial sponsors to convince sellers to take that alternative, even in open auctions."
Does that make the private equity firms and the advisor community despondent? Only in their darkest moments, but for most of the time the permanent residents of the Japanese LBO and leveraged finance village are an optimistic bunch.
Glass half full
"I like to see the glass as half full and I am cautiously optimistic that the tide is turning in favour of the sponsors," says Timothy Latimore, director of the financial sponsors group at Merrill Lynch in Tokyo. "Every deal completed is another feather in the cap for the industry."
Latimore sees a gradual cultural shift taking place within Japanese corporate management, helped by the weakening of the keiretsu system and cross-shareholdings. This, along with a new generation of management taking the reins of Japanese companies, is leading to increased independence of thought and action among owners and managers.
There seems little doubt that the invasion of foreign shareholders in the past decade is contributing both to a defensive posture by company boards and to the inculcation of a more return-oriented corporate culture.
At the end of the 2006 fiscal year foreign investors owned a record 28% of listed Japanese companies, becoming the largest single investor group for the first time, according to statistics released on June 15 by the Tokyo Stock Exchange and the other leading exchanges.
With net foreign buying continuing apace, many assume the 30% level will be breached within a year or two.
The second largest shareholder group was financial institutions, excluding investment trust funds, holding 26.4%. Investment trust funds own 4.7% of listed Japan, according to the survey.
Most observers also report that corporate management in Japan is becoming more confident about their prospects about being incorporated into a buy-out, having seen a rising number of positive entry and exit precedents across Japan.
There is also more facilitating government deregulation and legal changes to help squeeze out minorities, encourage stock-for-stock mergers and corporate restructuring.
In the private company sector and even stretching into the listed company sector, there is also a generational change taking place in Japan.
Post-war family-founders of companies are passing over control to the next generation and professional management teams are coming in and taking a more objective and dispassionate look at the companys future.
"Many post-Second World War entrepreneurs are facing succession issues, and private equity could be a solution for a number of such enterprises," says Latimore.
In the case of QSai Co, a manufacturer of kale juice, founder Tsuneo Hasegawa, who had served as president for 42 years, announced his intention in February last year to retire and hand his post to Takashi Fujino, who is from outside the founding family. The result was an MBO in co-operation with NIF SMBC Ventures Co.
In another case, the management of family controlled Skylark Co in July last year completed a tender offer to buy out the restaurant chain operator, subsequently de-listing the company from the Tokyo Stock Exchange in late September. At about ¥256bn, the deal beat the previous record MBO, the ¥223bn buy-out of World Co in 2005.
Looking at the exit gates
There is also an increasingly robust market for exits, highlights of which were the landmark $2bn February 2004 IPO of Shinsei Bank, and the May 2004 sale of Japan Telecom to Softbank after Ripplewood had held the company for little over one year, reaping an estimated four times or more return for the US private equity firm.
Among other notable exits, Lone Star undertook an IPO for The Tokyo Star Bank in 2005, valuing the bank at over ¥300bn; Nomura Principal sold a 65.5% stake in department store operator Millennium Retail to 7&11 Holdings for ¥131bn; and Carlyle merged publisher Gakusei Engokai with recruitment consultancy Intelligence Ltd in July 2006, later exiting its stake.
Before 2003, the sponsors were, with one or two notable exceptions, local funds and their exits were mainly sales to third parties as Japanese equity markets were less positive at this time.
From 2004 onwards, there has been a greater variety of sponsors leaving through a wider range of exit routes, including IPOs, strategic sales and a larger number of sponsor-to-sponsor sales.
According to the Japan Buy-out Research Institute, there were 296 buy-outs executed between 1998 to the end of 2006, with a total transaction value exceeding ¥3.5tr.
There were 69 deals in 2006 worth ¥918bn, a record for Japan.
The institute reported that 58 deals, half of the total number of exits, were made by trade sales through M&A, with the buy-out fund selling the shares of the portfolio company to another corporation, thereby revealing a trend towards increasing strategic M&A activity by Japanese companies.
The authors noted that 17 exit deals were made via secondary buy-out, in other words the original buy-out fund exiting by selling the shares to another buy-out fund. Some 13 deals exited via IPOs.
In recent years, the market has also produced an increasing number of leveraged recapitalisations, whereby the sponsor refinances the target company and pays its limited partners a dividend with the proceeds, or sells out to another LBO group.
Senior and mezz grow apace
There is now a bounty of senior debt available, relative to the dealflow, and the mezzanine finance market in Japan for subordinated debt and preference stock has grown rapidly since 2005 and is aiding valuations and dealflow.
"Global sponsors are undoubtedly pushing prices up," says Masataka Yamada, managing director of investment banking at JP Morgan in Tokyo, "justifying higher prices by more leveraged structures."
While Ebitda multiples have been in the range of four to seven times in Japan, six to even 10 times range has been possible due to more aggressive lending and the growth of mezzanine. Recent events in the US might change this, but it is too early to tell.
Mezzanine Corporations Sasayama recounts that at the start of the LBO market there was no mezzanine and the senior lenders were very wary, hence Ebitda multiples tended to max out at about four times.
"Since 2005 mezzanine has really grown very popular, as the valuation of deals has increased significantly," he says. "There is massive potential." ◗