Cherry-picking Japanese private equity funds

"I’m not sure I should tell you about this manager because I don’t want his fund to be oversubscribed,” confessed an anxious Japanese investment adviser to AsianInvestor.

Like all his peers, he is scrambling to find profitable products for clients suffering under Japan’s negative interest rate policy. Increasingly, the hunt for yield is guiding large and small investors alike towards a particular investment category: alternatives.

The world’s largest pension fund, Government Pension Investment Fund (GPIF) and Japan Post, the country’s biggest bank by deposits and insurer by assets, are poised to invest in alternatives. Many other Japanese asset owners have already begun shifting money out of negative-yielding government bonds and into these riskier but potentially more rewarding products.

“New classes of investors are entering the market. From GPIF and Japan Post to regional banks that are all seeking returns as well as ways to help the local economy,” Jun Tsusaka, founder of private equity firm NSSK told AsianInvestor. Tsusaka, previously of TPG Capital, is fund raising, said industry sources. 

Japan’s investors have so far focused on infrastructure and real estate funds among alternative products, according to some portfolio investment advisers in Tokyo. But domestic private equity funds are also attracting the country’s asset owners.

“Japanese private equity funds are looking more attractive to investors due to negative interest rates and the return on leverage,” said Kazuhiro Yamada, head of Carlyle's Japan buyout advisory team.

That is leading a fast-growing queue of private equity, real estate and hedge funds seeking handouts to establish new funds. Asian fund-of-funds and marquee global brands are likely to be the earliest beneficiaries.

The biggest alternatives manager in the world, Blackstone, is close to snagging a mandate from Japan Post to invest on its behalf, according to two people familiar with the matter. A spokeswoman for Blackstone declined to comment. Japan Post has also awarded Tokio Marine, Nissay and the Development Bank of Japan mandates to help it invest in alternative products, a source said. The Japanese firms did not respond to requests for comment. 

Other, homegrown funds are benefiting too. Japanese private equity firm Integral is looking to raise ¥70 billion ($692 million) for its latest fund, Advantage Partners is seeking ¥60 billion and Tokio Marine Capital is raising about ¥50 billion, according to some of the people the funds have approached to invest.

Even relatively new funds are gaining interest. One is Yukon Capital Partners, led by Ayumi Sakurai who previously ran Valiant Partners; another is Aspirant, headed by Akitoshi Nakamura, a former Morgan Stanley M&A banker.

Japan’s institutional investors will need to maintain some discipline and select managers who won’t use the flood of funds to overpay at a time when investment opportunities are scarce and fund performance data sketchy (many managers refuse to release metrics to data compilers).

Fortunately for them, AsianInvestor has done some of the initial due diligence on their behalf.

Japan performance
As China’s economy slows, its stock markets tumble from mid-2015 levels and regulators restrict private equity’s ability to sell companies on its stock markets, some investors are turning once again to more mature buyout markets – including the world’s third-largest economy, Japan.

“We are currently reconsidering Japan because China’s growth rate is declining,” said Yoshi Kiguchi, chief investment officer of Japan’s Okayama Metal and Machinery Pension Fund at the SuperReturn Asia conference in Hong Kong. "Over the next ten years in Japan and Southeast Asia we think we can get more than 10% net IRR."

Kiguchi currently allocates about 10% of his global private equity fund to Asia, mostly in China and has no exposure to Japan.  

“Japan is starting to look like an island of stability in a volatile world. And it’s no longer the one country in the world with zero interest rates, where companies need to focus on new sources of growth,” Mark Chiba, partner of regional private equity fund Longreach, told AsianInvestor.

Longreach has targeted ¥65 billion to ¥70 billion for its third fund and is launching a fund-raising drive later this year, according to market sources. Chiba declined to comment.

The excitement around Japanese private equity is understandable. Private equity funds focused on Japan generated an average gross internal rate of return (IRR) of 10% as of December 2015, based on exited investments between 2004 and 2013, which of course included the global financial crisis. That is higher than any other major Asian hot spot except for China, according to the Centre for Asia Private Equity Research.

To be sure many investors, both foreign and domestic, were burnt badly when Japanese private equity firms raised large funds in 2007 [see chart below] and invested them in highly-leveraged financial institutions and cyclical industrial companies such as Tokyo Star and Toshiba Ceramics. But confidence is slowly recovering.  

“It’s a little bit early to tell the final results, but Japanese vintage year private equity fund returns for 2009 and 2010 are very good,” said Kazushige Kobayashi, head of investment management Asia at CapitalDynamics.

Investors who pick the right Japanese fund manager can do particularly well.

Integral has hired Park Hill to help it raise ¥70 billion for its third fund, according to market sources.

Led by Nobuo Sayama, who also founded M&A boutique advisory firm GCA, the firm worked on the rehabilitation of Skymark Airlines from bankruptcy. This was a key deal for Integral, short for the not-so-catchy motto ‘integral calculus – accumulation over time’. This is the “fund to watch. Sayama is a rock star,” said one enthusiastic limited partner in Tokyo.

However some limited partners — also known as LPs — are keen to see more exits, including from Skymark, before they take the plunge.

Sweet spot
Some seasoned LPs warned against extrapolating a few deals that managers hit out of the park to sustainable performance. This is particularly good advice in Japan, where blue-chip corporates are generally suspicious of private equity companies’ focus on returns and rarely sell them big assets.

“Relationship management is more important in Japan, so if we can understand this then it helps us select the appropriate Japanese funds,” said Kiguchi.

Perhaps the sweetest spot for private equity in the country will be mid-sized deals, for less than $500 million, which are sold in secret negotiations. A stand-out deal in this respect was Advantage Partners’ ¥8.5 billion investment in Tokyo-headquartered condominium maker Community One (previously known as Dia Kensetsu) in 2008 at an enterprise value to Ebitda multiple of 3.7 times.

The roll-up strategy of five other companies into Community One resulted in a return of about 23.1 times money deployed, when Advantage finally exited in 2013.

Advantage Partners has lowered the target on its latest fund-raising effort to ¥60 billion from around ¥70 billion, after LPs requested it focus on smaller deals like Community One. The private equity firm said it had secured commitments from investors for ¥30 billion at the first close of the capital raising in an update to LPs.

Several LPs said that they were worried about recent departures at the firm. Atsushi Akaike left in 2013 and with Yukinori Sugiyama joined rival CVC Capital Partners in 2015. Akira Yamashita, who worked on the Community One deal, also departed the firm last year, said one LP.

But Advantage Partners still has one of the largest teams in Japan and averages over four transactions a year. Another home run by the team was its acquisition of 80% of Komeda in 2008, which generated 7.5 times money invested, according to LPs.

Many of these mid-sized sales are related to elderly Japanese looking to sell the companies they founded, often at a reasonable five to six times EV/Ebitda.

One specialist in this area is Sunrise Capital. Its purchase of a majority stake in cram school KK BC Holdings in Hiroshima from the founder Hiroki Tanaka in April is outperforming expectations, according to one market source.

CLSA Capital Partners is projecting its mid-sized Japan buyout fund Sunrise Capital, which it closed in 2014 at $210 million, will return 3.7 times invested capital in US dollar terms. It is currently tracking at around a gross IRR of about 38.1%, according to LPs. Sunrise Capital is now preparing to launch its third fund-raising, according to LPs.

That compares well to the median IRR for Asia-Pacific–focused funds, which was 12% as of June 2015, according to consultancy Bain & Co’s 2016 Asia Pacific private equity report. Top-quartile funds posted an average of 21% IRR, well above the 16% most LPs say they demand from their emerging Asia exposure, the report said.

The firm is raising Sunrise Capital Fund III this year, according to two people familiar with the matter. Existing investors in the fund are likely to receive preferential treatment, leaving scant space for any late-movers. Sunrise Capital declined to comment on its performance or on fund raising matters.

Yukon has just closed its first fund at ¥12.5 billion to spend on small-cap deals. It attracted a mix of foreign and domestic LPs; some of the local investors were dipping their toes in the asset class for the first time, said Sakurai.

Banking on alternatives
The Japanese asset owners with the biggest appetite for alternatives may be regional banks that are eager to improve investment returns hurt by the Bank of Japan’s negative interest rate policy.

Carlyle has been particularly successful at attracting regional banks into its yen-denominated funds. Several fund managers and LPs said they expect Carlyle to return to market next year to raise its fourth Japanese fund if they successfully seal some of the big carve-out deals they are chasing in Japan. The Washington-headquarted firm declined to comment on capital raising.

CITIC Capital Partners Japan is another standout in terms of delivering returns to investors. CITIC Japan Partners, a fund raised in 2005, delivered about 2.5 times money invested to its LPs while CITIC Capital Japan Partners II, LP raised in 2011, has generated about three times, according to one LP.

Its latest fund-raise is set to close this month and it is oversubscribed even though the fund manager asked its parent company to scale back, according to one investor in the fund. LPs said the returns on its investments in Japanese firms Higashiyama Film, Polymatech and Tri-Wall all generated positive returns to investors.

One industry source did, however, mention concerns about the fund going forward given that senior advisor Brian Doyle has stepped back from the business. A spokeswoman for Citic Capital said Doyle moved on over a year ago. 

Surprisingly, Japanese investors can be rather unforgiving if a private equity firm does stumble, as J-Star is finding.

After J-Star’s investments in the pharmacy sector were hit by harsher-than-expected rules on dispensing fees it has found foreign investors are more willing to bet on long-term growth in the sector — due to Japan’s aging population — than domestic LPs who are more concerned about portfolio companies’ performance dipping below budget, according to market sources.      

Carve-out specialist
As the Japanese government puts more pressure on corporate executives to improve their return on equity, it might be worthwhile for investors to look at specialists in buying the non-core operations of Japanese sprawling conglomerates.

Longreach springs to mind after the firm bought companies including Suntory, Hitachi and Sanyo. Longreach is set to open its third fund-raising to existing investors later this year and then reach out more widely next year, according to market sources.

Other funds looking to raise capital include Japan Industrial Partners, Polaris, J-Star and Ant Capital Partners, according to market sources and PEI Research & Analytics.

Of course, this surge in capital is having an impact on the valuations of prospective investments.

“A few years ago you could buy mid-cap companies at four to five times Ebitda; now it is getting more expensive,” sighed Sakurai as he contemplated the herd of private equity firms seeking capital for deals.

“Still,” he cheered up, “Given banks are willing to offer us plenty of leverage due to negative interest rates, our equity exposure is still very reasonable.”

With Japan’s asset owners increasingly desperate to find some extra juice from their investments, sourcing the capital shouldn’t be a problem either.

For private equity companies operating in Japan, the future looks bright, liquid – and increasingly crowded. 

This article was also published on AsianInvestor.net.