Carlyle kickstarts market
In the world of global leveraged finance, Carlyle Group is a true thoroughbred. It was one of the first of the big US private equity firms to come to Japan. Since opening its Tokyo office in 2000, Carlyle has developed an enviable reputation for dealmaking.
By late December 2003, when the firm announced that it had raised a dedicated ¥50bn Japan fund (Carlyle Japan Partners) to execute buy-out investments in Japan, it had already completed three buy-outs in the country.
Of the total raised in December 2003, nearly 60% of the commitments to the fund were from Japanese investors. As an indicator of the speed of growth of the financial sponsor market in Japan, Carlyle in July 2006 completed its second buy-out fund for Japan, raising ¥215.6bn, of which roughly half was sourced from Japanese investors.
Formidable track record
Carlyle has bought and exited a variety of companies from a range of business sectors in Japan. The firm acquired security services provider Asahi Security from the Daiei Group through a management buy-out in February 2002. In January 2005, Toyota Industries agreed to acquire Carlyles entire stake in the company, valuing the equity at ¥19.5bn.
In the three years that Carlyle owned the company, Asahi Security built or expanded several business centres, increased the number of employees from 2,000 to 2,600 and doubled the number of customers.
Carlyle founding partner and managing director David Rubenstein said after the sale to Toyota: "This was Carlyles first buy-out in Japan. We believe this transaction raised the corporate value of Asahi Security and demonstrated both in Japan and abroad that private equity funds can successfully contribute to new business developments."
Far from plain sailing
But it has not been an easy road, by any means. In the Japanese MBO village, local legend has it that Rubenstein faced severe difficulties in trying to open a Japanese operation and to hire top professionals.
At that time Japans financial system was still intensely troubled and its corporations were struggling in a weak domestic economy. In that environment, private equity firms were viewed with intense distrust and senior bankers and executives were wary of leaving their career jobs for a punt on firms such as Carlyle and on the nascent LBO market.
According to some reports, private equity funds committed in Japan during the 1980s were valued at less than $100m, compared with more than $50bn in the US in the same period. "But things have changed," says Masato Marumo, managing director at Carlyle in Tokyo. "Not only has more and more money been raised and targeted to LBOs, but some of the full and partial exits have proved that there are spectacular returns available, especially linked to the originally more distressed deals."
Marumo is focused on Japanese buy-out and other investment opportunities, with particular focus on the telecom, media and technology (TMT) and financial services sectors.
Before joining Carlyle, he was a vice president at Industrial Bank of Japan (now Mizuho Corporate Bank) where he was the founding member of the private equity department. Before that, Marumo worked in other areas at IBJ such as financial advisory, credit risk management and structured finance.
Carlyle cuts teeth on Willcom MBO
Carlyles biggest investment to date was the October 2005 purchase of 60% of Japanese cellphone maker DDI Pocket, renamed Willcom Inc, in a $2.1bn buy-out.
It was the deal that signaled the arrival of Carlyle as a leading force in the Japanese market. But it was also a tough deal that required immense patience and an ability to tread the very fine line between driving a hard bargain while keeping the right side of fair.
Marumo acknowledges that leveraged transactions in Japan are much more widely accepted in the less than three years since Willcoms financing concluded, citing the jumbo Softbank/Vodafone deal late last year.
"That seems to confirm what at one stage might have seemed unimaginable, namely a dramatic increase in leveraged loan appetite among the senior lenders."
Marumo recalls that the Willcom deal was especially tough because of the lack of senior lenders for deals at that time, as well as the complete absence of mezzanine finance.
The Willcom transaction was, in the end, financed by a group of six domestic and international banks. "It was tough to get their support, whereas today it would be fairly straightforward on a deal of that size, structure and quality to source the senior portion from just one leading bank," he says.
He recalls the transaction with a mixture of pride and pain. "Dealing with the equivalent of we can now jokingly call a six headed dragon was extremely tough. Day after day, night after night, were spent in lawyers offices in incredibly difficult and complex negotiations. In truth, there were at times some fairly ugly dynamics."
No pain, no gain
But Marumo argues that out of the pain has come a lot of gain. "We achieved a huge breakthrough in that deal, as it helped Carlyle assure the leading senior lenders in Japan that although we were tough negotiators, we were also fair. In hindsight, the deal helped us and the lender community to understand each other well and consequently we have been able to work very constructively together on subsequent deals."
Marumos background and his years on the credit committees of big name banks in Japan helped him present a sensitive face to the requirements of the senior lenders. "That no doubt helped us all distinguish each others lines in the sand," he says.
Apart from more acceptable faces of leveraged finance deals in Japan today, in the three years since the Willcom deal Marumo has also seen a big advance in the response time and the sophistication of deals, not just of the megabanks but of a variety of lenders.
"I can get a dozen term sheets from a dozen lenders within 30 minutes of a telephone call," says Marumo. "These days it is not only the megabanks and leading global banks, but also the global investment banks, the latter category being lured by huge loan underwriting fees to boost their M&A fee income."
Toshibas landmark divestment
Carlyle more recently concluded the purchase of formerly listed Toshiba Ceramics from Toshiba Corp, which changed its name to Covalent Materials Coporation in June. The roughly $1.2bn transaction was concluded last year and was financed by ¥50bn of equity from Carlyle and Unison Capital, ¥25bn of mezzanine funding in the form of preferred equity from Chuo Mitsui Capital, and ¥65bn of senior from Mizuho Corporate Bank, SMBC and Royal Bank of Scotland.
"This was not only a landmark divestiture of a non-core operation by a blue chip, but also Japans largest ever tech sector LBO," says Marumo.
Not only did the buy-out achieve a smooth financing package, but Carlyle and Unison also obtained ¥30bn for a capex facility tied to the construction of a new manufacturing plant. "To secure finance for growth in a leveraged deal in what is considered a highly volatile sector was a formidable achievement in the context of Japans short MBO history," Marumo says.
Toshiba Ceramics business was roughly divided into two operations, silicon wafers and ceramics. Marumo explains that in the silicon wafer business the received wisdom is that a brutal economy of scale is required to survive. "The company had only a 4.5% global share, suggesting that it was under the scale required and eventually would be beaten out of the market," he says.
Scratching beneath the surface
But when Carlyle and Unison investigated the company, they found that it produced a differentiated product in the wafer industry, in which it was a global market leader with a more than 50% market share. "The base story for other potential buyers was to keep the ceramics and cut the wafers," he recalls, "but our purchase presented a holistic vision to the seller and to the management team."
That vision was based largely on the insights shared with Carlyle by the CEO, Dr Susumu Kohyama, who convinced it that there were great synergies between the two parts of the business and that the company would therefore not be dragged into the scale game.
The precise details of the pricing and the structure are confidential, but Marumo claims that the returns to the lenders fell within the general parameters he had outlined.
"More interesting than the pricing," he says, "we obtained some concessions on the covenants and a quasi back-loaded funding with a partially amortising senior tranche. Being a cyclical tech sector company, we wanted as much reporting headroom as possible to ensure that we had sufficient flexibility if faced with a downturn."
Marumo also notes that although the tech sector is volatile, its volatility is declining because, say the experts, of the proliferation of semiconductor applications.
Growing portfolio of success
Among other buy-outs, Carlyle has completed are: patient and blood pressure monitors company Colin Medical Technology Corporation; broadband access provider eAccess Limited; job placement company Gakusei Engokai Co Ltd,capsule maker Qualicaps Group; crane and hoist manufacturer Kito Corporation; high-end autoparts manufacturer Rhythm; and integrated provider of silicon wafers and other ceramic materials, Covalent Material.
With that sort of track record, it is unsurprising that Marumo is positive on the outlook of the LBO market in Japan. The headline Japanese private equity transaction to date in Japan is Ripplewoods brilliantly timed purchase of LTCB and its renaissance as Shinsei Bank, which listed in 2004.
But not all great investor rate of returns are mined out of distressed assets. "Some of our deals, without focusing on turnaround situations, have also produced outstanding returns," says Marumo.
Marumo argues that Japan has the potential to be one of the most attractive markets for private equity investments. He notes that the Japanese economy, the second largest in the world, is home to some of the worlds most successful companies with leading technologies, skilled labour forces, and highly educated management teams.
"With our global investment experience and wide knowledge of so many industry sectors over the past two decades, we are extremely well placed to bring the best out of businesses and their management teams in order to maximise the portfolio companys value," he says.
According to a Bloomberg news article, the US had returned 12.4% annually in the decade to September 30, 2005, compared with a 7.7% annual return from the S&P 500.
"The numbers are in our favour," says Marumo. "Now we need to accelerate the pace of dealmaking, but to do so requires additional support from the Japanese management community and a reduction in the scepticism and wariness among the public at large."
Local knowledge can be an Advantage
Local private equity firm Advantage Partners has played leading roles in a host of landmark deals, such as the buy-out and de-listings of Pokka Corp and Rex Holdings, and more recently the leveraged buy-out of MEI Conlux from Mars Inc.
But with competition for leveraged deals intensifying, can the firm retain its leading edge?
Richard Folsom might not be Japanese, but as co-founder and representative partner of Advantage Partners he has used 23 years of experience in the country to help the firm become what most would consider Japans most successful home grown private equity firm.
"A steady flow of high quality opportunities has been critical to our success thus far," he says. "We have developed a network of relationships across the length and breadth of Japans corporate, financial and deal-making landscape."
Advantage Partners sits mainly in the middle market, believing that the potential returns are generally higher here than for the larger deals. It therefore focuses its efforts mostly on companies with sales in the range of ¥5bn-¥100bn, but the firm can go much larger, if the right opportunity arises.
Mid-market but high profile
Advantage has established several funds to invest in management buy-outs, buy-ins and other private equity opportunities. The firm has a long history as a market participant from the very inception of Japans buy-out market.
It established its first fund, at just ¥2.95bn, in October 1997. That money came from 10 domestic institutional investors, and plenty more have queued up to buy into ever-larger funds.
Advantage finalised its second fund in January 2000, sized at ¥18bn. Since then it has closed its third fund at ¥47bn and most recently the firms fourth fund more than 70 times the size of the 1997 fund at ¥215bn.
"Private equity is a catalyst for M&A," says Folsom. "In the early years in Japan, the first deals were primarily distressed companies or restructuring situations, especially with the banks troubled and unable to continue to fund distressed companies. That was the environment in which we began operations here, but the market has evolved to one in which dealflow is increasingly driven by profitability."
Out of the darkness
Up to 2005, the market was dominated by turnaround and distressed deals, but the World Co and Pokka Corp buy-outs demonstrated that there was a growing interest in what was then a new trend, namely going-private transactions.
One service Advantage likes to see as a unique strength is providing new avenues for wealth creation among a managerial class previously driven by the concept of career rather than personal financial and corporate motivation, which has helped employees to swallow the LBO pill more readily.
Advantage encourages employees at the firms it buys to take equity, on the same terms as those at which Advantage buys in. "Alignment of interests and motivation are key and it has proved very successful so far in helping overcome some cultural and personal reluctance to LBOs," Folsom says.
The companys website uses the example of Yasuhiro Mori, hired by the firm from apparel company Renown to serve as CEO for Advantage portfolio company Actus, a furniture retailer.
It says that Mori jumped on the opportunity because it allowed him to manage a company as much as a decade earlier than he might otherwise have done in Japans hierarchical corporate management culture.
The sands shift
A key change helping Advantage and other MBO sponsors has been the decline of cross-shareholdings, as well as the rise of foreign shareholders in Japan, that now represent more than 28% of the listed stock on the Japanese bourses.
"There is no doubt that the decline in the old cross-shareholding by banks and group or related companies, combined with the rise of more return-focused foreign investors, have helped this market grow apace," says Folsom.
He also notes some facilitating regulatory improvements, especially in anti-trust laws which allow financial sponsors to make majority acquisitions. "Meanwhile," he adds, "the equity capital market has improved for exits via IPO, and the intensification of M&A activity has led to more appetite for assets that we later sell."
Folsom argues that the private equity firms have also brought a new intensity and professionalism to the M&A market, with a focus on due diligence.
Patient Permira takes phlegmatic approach
In Japans increasingly competitive market for buy-outs, new entrants must retain their focus and also a sense of perspective. Leading European private equity firm Permira opened its Tokyo office in the autumn of 2005, but has yet to complete a deal. EuroWeek asked Alex Emery, principal at Permira Advisers KK in Tokyo, if the long wait is taking its toll.
Permiras Japan operation is not short on talent. When it opened its doors in the autumn of 2005, the firm appointed Tomoya Shiraishi as its new president. He joined after a long career at Jafco, a leading Japanese publicly traded private equity firm. He had been group officer of Jafcos widely respected buy-out investment division, which he helped found in 1998.
The firm has assembled a host of other talent. Emery first joined Permira in London in 2002 and moved to Tokyo to help establish Permiras Japanese presence in 2005. Before joining Permira, Emery spent five years at McKinsey & Company in London.
Settling in for a long innings
Permira Advisers has thus far not concluded a buy-out transaction in Japan. But Emery and the Permira team hold on to a sense of local perspective. "We are frustrated, of course, but we are certainly not dismayed," he says. "From a global perspective, we have eight offices and we would seldom expect to do more than eight deals a year, so each office would on average get one deal done each year." He notes that the firm takes a patient approach to its investments. Permira opened its Stockholm office in 2003 and it took three years before its first deal there.
However, when it came it was important, the first deal being the record buy-out of TDC, the Danish telecoms company, for Eu12bn. And the New York office, opened in 2002, similarly took three years before closing in on its first deal.
"We always knew Japan was going to be a difficult market for us to break into," Emery says. "However, we also felt that it was essential for us because of the size of the countrys corporations, the growing trend towards M&A and the historic ambivalence shown by management towards shareholder returns and rights."
Typical sources of transactions for Permira will include corporate spin-offs, family buy-outs, growth buy-outs, turnaround situations, public to privates and cross-border build-ups.
Combing Japan for opportunity
A specific focus is on companies in industries that fit with Permiras strong sector expertise in areas including chemicals, consumer, healthcare, industrial products and services, and TMT.
"At the mid-size company level," Emery observes, "there are a huge amount of companies. They are sometimes fairly sleepy, risk-averse, and produce steady rather than exciting returns for shareholders."
A central problem for management-friendly buy-out groups such as Permira is that management teams have in recent times become more and more defensive and more entrenched, partly many private equity specialists argue due to the activities of some local and foreign activist funds.
There is little doubt that underperforming companies could be encouraged to reverse sub-par returns if there were a regulatory and corporate governance environment in Japan that is somewhat more friendly to external parties pushing for higher returns.