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Working up an appetite

30 Sep 2002

Many of the building blocks are in place for the expansion of the private equity market in Japan: low asset prices, a real need among corporates to restructure; workable bankruptcy laws and an established and liquid local banking industry. Critically, though, appetite among the big Japanese banks for the provision of leveraged debt remains low.

Think about the perfect environment, theoretically, in which private equity should thrive.

It would be an environment in which the prices of publicly quoted assets are depressed; one in which the corporate landscape is heavily populated by vast, unwieldy conglomerates, commercial logic would suggest, ought to be broken up to allow their component parts to focus more efficiently on their core strengths; one in which there is a sophisticated and open banking industry flush with liquidity; one with a well developed and accepted legal system; and one in which the dangers of lending based on inflated asset values rather than future cashflows have been brutally exposed.

On that basis, Japan looks like a market that has been constructed and shaped for the benefit of the private equity industry.

Into that particular pot can now also be stirred what is a relatively new phenomenon in Japan: increased concerns over corporate governance laced with shareholder activism. Historically, and even in the midst of a seemingly endless bear market, Japanese institutional investors have been renowned for their passive acceptance of feeble returns, apparently prepared to accept an environment in which a large number of listed companies now trade well below their asset value.

One investor no longer prepared to put up with such consistently awful returns is the former trade ministry bureaucrat, Yoshiaki Murakami, who is now president of M&A Consulting. Murakami began to make waves in Japan in 1999 when he started urging local pension funds to exert more pressure, Calpers-style, on underperforming publicly listed companies.

Murakami's most recent broadside, which became something of a cause célèbre in Japan, was against the women's apparel maker, Tokyo Style.

That particular bout of activism was aimed at compelling the cash rich company to increase its dividend, buy back its own stock, or preferably both. Although it failed - much to the disappointment of a number of equity analysts and international investors - bankers say that its symbolic importance should not be underestimated.

German example

After all, when some iconoclastic agitants began to raise their voices in Germany in the late 1980s and early 1990s their pleas for improved corporate governance fell largely on deaf ears. If Japan can make as much progress in the sphere of corporate governance as Germany has in recent years, it will certainly widen scope for an acceleration in restructuring and, by extension, more activity in the private equity area.

Certainly investors seem to be believing that this does lay the groundwork for increased opportunities in the Japanese private equity market. According to figures published by the Asia Venture Capital Journal, the amount of new money channelled into new dedicated funds exploded from just ¥140bn in 1998 to ¥497bn in 1999 and ¥529bn in 2000.

It was the combination of all these factors which, two or three years ago, led to a handful of the international banks making a strategic decision to establish Tokyo-based teams dedicated to a range of leveraged related products, all designed to capitalise on the coming boom arising from corporate restructuring in Japan. Among other things, this restructuring led to an explosion of LBO and MBO activity.

Some of those teams despaired at the sluggish implementation of reforms in Japan. They weren't the first (and won't be the last). As a result, the teams came, saw, and more or less gave up in pretty quick order.

A notable exception, however, was the Deutsche Bank Group. "We were the first bank to offer the full range of leveraged products in Japan, and the reason we established this operation in the first place was that we felt all the ingredients were here to make this a successful market for high yield and leveraged finance," explains Kristoffer Mack, managing director and head of global debt products at Deutsche Securities in Tokyo.

"There are at least 20 financial sponsors here, all of which have plenty of cash to invest, while on the other side Japan is full of investors who are short of high quality, high yielding products."

Deutsche's benchmark

Deutsche's Japanese leveraged business landed on its feet quickly, and by September 2000 it was proudly declaring that it had successfully completed Japan's first ever high yield bond offering.

This was a ¥6.5bn privately placed transaction for Orient Service Center Corporation (OSC), a medium sized consumer finance company formed by a merger between Orient Shimpan and Fuji Cash Service. OSC had recently been acquired by Unison Capital Partners, an independent Japanese buy-out fund.

Six months later, Deutsche put another feather in its Japanese leverage cap, announcing at the end of March 2001 that it had arranged and completed Japan's largest ever leveraged buy-out financing for Victoria, a leading local sporting goods retailer. The acquirer was the Japanese private equity firm Jafco, which injected ¥8bn of equity. Deutsche structured three complementary debt components with an aggregate value of ¥27.5bn made up of a senior secured credit facility, a ¥6.5bn high yield bond and a facility allowing for the sale and leaseback of 12 of the Victoria stores.

Mack describes the structure of the Victoria transaction as remarkable. "It brings together so much of the technology of western financing techniques co-mingled with a leveraged lease and the freeing up of real estate assets, and it was all done as an out of court restructuring," he says.

He believes the deal provides an ideal template for future transactions structured along similar lines.

Some of Deutsche's competitors within the gaijin investment banking industry in Tokyo downplay the bank's brace of high yield deals in Japan. They say the deals, which were privately distributed transactions, which were so tiny as barely to have made a pin-prick in terms of developing a new asset class within the Japanese capital market.

That seems churlish, not least because irrespective of their size, Deutsche has endeavoured to use these deals as a means of spreading the word about high yield bonds and their role in corporate restructuring among domestic institutions - which can only be positive.

"We structured both bonds to make them acceptable to international investors," says Mack, "meaning that the covenant package and pricing formula were borrowed from the US market. But our main objective was to try to create a market here, and we felt that the only way to do that was to encourage domestic demand.

"It is difficult to develop a market without strong domestic participation, and we worked very hard at an educational level on finding appetite for the product within Japan. The result was that we sold both bonds almost exclusively to local investors, although we could probably have sold them much more quickly and with much less up-front work had we gone straight to the international market."

The effort, Mack insists, has already been rewarded. "The Orient Shinpan bond in particular has been a fantastic success, and has traded significantly above par," he says.

3i open for business

Another European player in the Japanese buy-out market to have scored a notable success soon after the establishment of its Tokyo office was 3i, the UK private equity firm.

3i first arrived in Asia in 1997 when it established a Singapore office. That was followed with a Tokyo office in 1999 and a presence in Hong Kong in 2001. According to Mark Thornton, the managing director who runs 3i's Asia Pacific buy-out business from Tokyo, each Asian outlet has a slightly different focus.

"In Singapore, most of our investment has been into early stage technology because the government there has been very actively involved in encouraging entrepreneurs to launch tech-based start-ups," he says. "So 3i now has a share of about 20% in the early stage market in Singapore. In Hong Kong, we opened an office in order to focus on the opportunities in Korea and Greater China, where we see great potential for the future.

"And in Japan we are focusing almost exclusively on buy-outs, because we believe that many of the large corporates that are heavily indebted will be forced to focus on their core strengths and sell off non-core activities to streamline their businesses."

Last year, in what was billed at the time as Japan's largest ever MBO, 3i acquired the 74% shareholding owned by Nissan in Vantec, which had originally been founded in 1954 with the specific mandate of providing logistics services to the auto manufacturer. Vantec had a turnover in the last full year before its MBO of some ¥63bn, and made operating margins of about 2%.

The size of the buy-out was $130m, par for the course for Japan, with funding split roughly 50:50 between the equity injected by 3i and the debt provided by Mizuho. Since the buy-out, says Thornton, 3i has brought in a non-executive director from Europe who has advised on how to take the business forward and, more particularly, on how to lessen its dependence on Nissan as its principal customer.

Already, he adds, Vantec has made considerable progress in this respect, and its revenue is now divided more or less equally between Nissan-related and non-Nissan-related business.

Successfully concluded transactions like Victoria and Vantec have been encouraging pointers for lenders and private equity players alike. So too has been a more recent deal rewarding the effort that JP Morgan has put into the broader acceptance of leverage in Asia.

Some six months in the making, this modestly sized buy-out for Tower Records presents a curious case of role reversal, resulting as it has from corporate distress in the US and, by comparison, stability and growth in Japan.

In April 2002, Nikko Principal Investments Japan (NPIJ) reached an agreement with MTS Incorporated to acquire the US company's entire holding in its Japanese subsidiary, Tower Records (Japan), a retailer and wholesaler of CDs, videos and books. Ironically, this agreement was a by-product of the insistence by MTS's bankers in the US on the restructuring of the company as a means of reducing its rapidly spiralling indebtedness.

An optimal capital structure and leverage allowed NPIJ to successfully beat out at least three other bidders for the Tower Records asset. Debt to capitalisation was just over 50% and the leverage was 3.1 times Ebitda, which bankers report as being in line with a rule of thumb ratio for a speciality retailer.

No great shake

At JP Morgan in Hong Kong, vice president of debt capital markets Eric Mason acknowledges that at ¥8.75bn, the fully underwritten acquisition financing for the Tower Records buy-out, which was closed in July, is hardly going to be earth-shattering in terms of its size.

More important, as far as he is concerned, is the precedent it establishes for the financing of buy-outs in Japan. "We applied proven technology, as well as global pricing and structural enhancements and ran the syndication process just as we would have done in any other market, rather than following the club-style rules that are normally used in Japan," says Mason, who ran the deal for JP Morgan.

"We had a very interactive approach with potential lenders, which is not standard practice in Japan, including hosting one-on-ones and bank meetings, providing full disclosure and transparent term sheets and inviting other banks to sub-underwrite the deal, and the response was overwhelming."

Ultimately, 11 banks joined the syndicate, nine at the sub-underwriting level, of which eight were non-Japanese.

"None of the big four Japanese banks came into the deal," he says, "but what was very encouraging was the cross-section of Japanese, regional and European banks that have committed to the transaction, such as UOB, Korean Exchange Bank, HypoVereinsbank, HSBC, ING and WestLB."

That response was achieved in spite of the pricing which was perhaps on the tight side at 225bp over Tibor for the five year tranche and 325bp over for the seven year tranche. "We were able to develop a value-added debt structure learned from previous transactions," says Mason. "In the case of Tower, we structured a five year term and revolving credit as the pro rata tranche and a seven year tranche with a back end amortisation as a stretch senior tranche geared more towards institutional-type players. With Tibor at almost zero and credit spreads in Tokyo still relatively low, the Tower Records financing offered both lenders and investors very clear relative value.

"It is likely that had we priced the seven year tranche higher we could have attracted more banks."

Record breaker

For NPIJ, which has been open for business in Tokyo since March 2000 - adding to its London franchise set up in June 1998 - the Tower Records deal is an important one as it is the first time it has used leverage to structure a buy-out.

Before this deal, says NPIJ's president and CEO, Hirofumi Hirano, the bulk of its transactions in the Japanese market had been early stage venture capital-style investments, principally involving direct equity investment and often working in tandem with Citigroup Venture Capital and CVC Asia Pacific, a relationship that has emerged and prospered as a by-product of the Citigroup/Salomon Smith Barney merger.

"We and CVC have worked together in looking for Japanese buy-out opportunities," says Hirano, "and it is a very complementary fit. We have a very wide and deep network here in Japan, while they have strong portfolios of companies globally that would like to expand their operations to Japan."

So much for the good news about the market for private equity and leveraged loans in Japan. The bad news, say the sceptics, is that relative to the size of the economy the total number of transactions that have been completed, although growing, remains little more than a drop in the ocean.

At 3i in Tokyo, Thornton says there have been about 150 buy-outs in Asia since 1998, about 50 of which have been in Japan, with two in 1998, five in 1999, 15 in 2000, 20 in 2001 and about 10 announced in the first half of this year. While that represents an encouraging momentum, it is still a tiny total for the second largest economy in the world, especially given that the vast majority of buy-outs are still in the $50m-$150m range.

Fear of commitment?

Whether or not that figure can rise very meaningfully over the coming five to 10 years depends on the extent to which Japan can develop a genuine and irreversible commitment to restructuring in the way that Korea has.

On that score, the jury is still out. At Deutsche in Tokyo, Mack concedes that of all the elements in the leveraged market, the availability of assets remains the logjam that continues to limit significant growth in the market. "The fact is that in spite of the difficult economic environment there is still an acute shortage of quality assets for sale," he says. "Conglomerates are still retaining their subsidiaries and everything still seems to be seen as core, which has been the most frustrating aspect of this business for all of us. But we always knew this would be a long and slow process."

For those who are bullish about the potential for entrenched Japanese attitudes to change rapidly, prising open a bigger pipeline of private equity transactions, a report published in July by Goldman Sachs makes exciting reading. "One reason to be optimistic about the future of Japanese corporate restructuring," this notes, "is that, similar to the 1974 adoption of ERISA [the Employment Retirement Income Security Act] in the US, the recent introduction of new guidelines for exercising voting rights has caused Japanese institutional investors to exert more pressure on company management than ever before."

As a specific example of this pressure, the Goldman analysis commented on local press reports to the effect that Nippon Life, a colossus among Japanese insurance companies, plans to start analysing in detail the management of companies in which it has stakes if their share price has fallen by more than 50% during the previous three years.

"If Nippon Life concludes that prospects for management improvement are slim, the firm intends to vote against nominees for boards of directors and other resolutions," notes the Goldman report. "It will also vote against management proposals if the firms have lost money and paid no dividends for two to three consecutive years. Apparently, Nippon Life planned to cast negative votes at the shareholders' meetings of an many as 400 Japanese companies in the 2002 AGM season."

Fine. But this begs three very obvious questions. First: why has it taken so long for a heavyweight institution such as Nippon Life to reach a decision of this kind? Second, why will it only look at companies whose share price has fallen by 50% in three years? And third and most important, will its final action on these companies amount to a gentle slap on the wrist or to genuine pressure for change?

Those who suspect that the initiatives of an investor such as Nippon Life are based more on rhetoric and less on a genuine commitment to shareholder activism will have had their suspicions at least partially confirmed by a recent report in the Nikkei Weekly, which noted that although the insurance company had suggested that it might vote against management proposals in 400 companies (as indicated in the Goldman Sachs analysis), "in actuality, Nippon Life cast negative votes at meetings of fewer than 10 companies."

Investor caution

Against this apparently contradictory background, it is unsurprising that local private equity investors are guarded in their views about prospects for the sort of thoroughgoing change they would need to underpin their business - as well as to justify the investments they are making in their Japanese operations.

At JP Morgan Asia Equity Partners in Tokyo, for example, John Lewis agrees that there are factors that are supporting and impeding growth of the private equity market at the same time. "One of the negative elements is that we have not yet seen genuine pressure being exerted on companies by outside shareholders to restructure themselves and sell off attractive assets in the same way we have seen in Korea," he says.

"And the second negative element is that growth in the overall economy is so slow that it can sometimes be difficult to get excited about the growth prospects of individual companies operating within this environment."

Others agree that Japan's depressing, deflationary macro-economic backdrop is an obvious weakness in the argument of those that are enthusiastic about the longer term prospects for private equity in Japan.

Having piles of cash sitting within private equity firms looking for investment opportunities is one thing, argue the sceptics; finding the sort of viable investment opportunities that can provide the sort of returns that private equity investors insist on is something different altogether.

And some Tokyo bankers report that they believe many of the private equity firms that have been very successful in raising funds may now have presented themselves with an almighty headache about how to invest those funds.

While Lewis at JP Morgan Asia Equity Partners acknowledges that standards of corporate governance (on the one hand) and the state of the economy (on the other) act as drags on the expansion of private equity in Japan, he is also convinced that another important and positive new development outweighs both of these negative influences.

"Over the last couple of years there has been a growing recognition that an MBO can be something that is very much in the interests of both the selling company and the management team, and that it can play a very important part in advancing the process of restructuring," he says. "What I am hearing from investment banks in Tokyo today is that staff at the big conglomerates are increasingly initiating talks about whether or not they should be considering buy-outs and talking to private equity investors.

"That is a marked departure from the past when private equity players were generally seen as little more than vultures who were planning to come in to buy companies, cut them up in pieces and sell them off."

That, he says, is understandable enough: "A lot of the preliminary activity among the foreign private equity investors was focused on distressed assets, and it has taken a while for management teams to recognise that private equity firms doing MBOs are going to support the company, form partnerships with management and help it to grow over time, which is certainly what JP Morgan Partners aims to do."

Change under way

In tandem with this development, Lewis detects an important cultural change among Japanese management teams which would be pivotal to the growth of a more developed private equity market in Japan.

This is a gradual erosion of the values that have characterised Japanese industry for decades - manifested, among other things, in consensus-based decision making - and their replacement by a more entrepreneurial mentality.

"Of course many management teams in Japan are still less willing to take on risk than their typical counterparts in the US or the UK," Lewis says. "But we are seeing clear evidence that a growing number are very attracted by the idea of achieving independence and the empowerment to run their own company without all the bureaucratic entanglements associated with being part of a large conglomerate."

As an example of this trend, Lewis points to a deal that JP Morgan Partners is now working on in which a conglomerate is spinning off a subsidiary. He explains that in this instance, which he describes as being unique in Japan, the selling company offered management the option of choosing the company's buyer, subject to price negotiations.

In the event, management decided that it would prefer to plough its own furrow in a buy-out with the support of a private equity investor, specifically because it wanted to demonstrate what it could achieve on its own.

If the evolution of a successful private equity market in Japan depends to some degree on the emergence of entrepreneurial attitudes such as these, there are plenty of other cultural issues that also need to be addressed.

One of the most obvious of these is entrenched Japanese attitudes towards labour relations. Firms would be unlikely to take kindly to a private equity investor marching in and announcing swingeing job losses as a means of cutting costs and maximising returns.

Trimming the fat

Gradually, say analysts in Tokyo, Japanese companies are coming round to the idea that they need to trim their labour forces, but at the same time they remain adamant that they will do so according to their terms, rather than to those of outsiders with little or no interest in Japanese social fabric. "We do believe that Japanese companies are becoming pretty serious about restructuring," says Takahiro Morita, managing director of the corporate ratings group at Moody's in Tokyo, which rates some 210 Japanese corporate borrowers.

"Almost every company we rate has achieved its stated goals in terms of cost cutting, and we are now seeing a number of companies serious about reducing their labour force. But they won't do so through straight lay-offs. It will be based on early retirement plans, natural wastage or relocating workers to subsidiaries where they accept lower salaries. So things are changing, but in a Japanese style."

Over and above the issue of liquidity within the labour market is the thorny issue of the structure of corporate relationships in Japan, which have traditionally been based less on hard-nosed commercial logic and more on historical allegiances and loyalties, none of which are going to cut much ice among private equity investors in pursuit of worthwhile returns.

"When we decide to invest in a company our main internal question is whether we can enhance its efficiency and productivity," says Hirano at NPIJ. "Of course the size of the workforce is one consideration, but improving operating performance does not necessarily mean sacking people. The sort of questions we ask are: does a company need to be buying from a particular supplier based on historical relations? Does it have to continue to give big discounts to its parent company? So there are a number of potential constraints of which employment contracts are only one."

Banks must play their part

Like the state's commitment to restructuring, lending banks' commitment to leveraged lending is is under question. Market observers are unsure if there is yet sufficient commitment among the banks to providing the sort of leveraged lending facilities that private equity investors and buy-out teams would need in order to make their deals feasible.

Of the foreign banks that are active in the leveraged loans market, local bankers say that only Deutsche Bank seems to be showing genuine long term staying power, with JP Morgan now covering the market from Hong Kong and Citigroup reluctant to stray too far from its core franchise of serving multinational corporates.

Meanwhile, some Tokyo-based private equity firms say that of the Japanese banks only one - Mizuho - has formed any kind of commitment to leveraged lending, and that with the local banks continuing to enjoy an overwhelming dominance of the domestic lending market, that inevitably means that there are restrictions on the degree to which supply of leveraged facilities can be expected to grow.

"I agree that we have many of the building blocks in place for the expansion of the private equity market in Japan," says Hirano at NPIJ. "But one of the critical things we still lack is the appetite among the big Japanese banks for the provision of leveraged debt."

Others also express reservations about the willingness of the Japanese banks to put their weight behind leveraged loans.

"I'm not a strong believer in a new trend of highly leveraged transactions being established in Japan," is the view of Harunobu Yamada, chief executive of corporate finance and advisory at HSBC Securities (Japan) in Tokyo. "It is not surprising that banks should be very credit conscious, given the ever-increasing proportion of bad loans within their portfolios, and therefore very cautious when it comes to leveraged transactions without any recourse to creditworthy counterparties."

At the same time, Yamada adds that Japanese banks' balance sheets are shrinking, but their exposure to Japanese government bonds (JGBs) is increasing because the leading players need to ensure that they adhere to the 8% BIS ratio for tier one capital.

As an obvious by-product, the capacity of Japanese banks to increase their lending to the private sector is being severely diminished.

Plumbing the depth of funding

On the other side of the coin, some private equity investors in Japan say they are surprised at the contention voiced in some quarters that funding for buy-outs is a constraint.

"My experience is that finding banking facilities here is quite straightforward," says Thornton at 3i in Tokyo. "When I was looking at deals in Hong Kong the bank lending was much more difficult to come by. There, I was talking almost exclusively to the foreign banks like JP Morgan and UBS Warburg.

"In Japan things are very different. We have found that the most aggressive proposals come from the Japanese banks. They are hungry to do deals and they can generally beat the foreign banks on pricing."

In part, Thornton says that that may have something to do with the size of loan facilities that a player like 3i is generally looking for in the leveraged loans market. "At 3i we tend not to aggressively gear our businesses," he says. "We would rather give them scope to grow and don't rely on making a return through financial engineering."

As a result, Thornton says that in a typical Japanese buy-out 3i would be looking for debt facilities of about $50m to $100m, which he adds might well be too small for the foreign banks to look at with much favour.

At JP Morgan Asia Equity Partners in Tokyo, Lewis agrees. "I think there is adequate funding available both in Japan and elsewhere in Asia," he says. "Mizuho in particular has been very active and local banks such as Aozora and Shinsei are also becoming increasingly involved in the leveraged loans market. The sophistication of the market in terms of deal structuring has evolved fairly rapidly and we certainly haven't encountered problems in raising debt financing at reasonable levels of leverage.

"I don't think you can really push the envelope in terms of debt to cashflow, but that is not something we would look to do in any case." *

30 Sep 2002