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Reasons for Outperformance
What are the reasons for
outperformance? It’s a textbook
combination of cheap entry prices,
the effect of leverage, and operational
improvements. However, there
are subtle differences to each
component in any market.
First, the cheap entry price in Japan
is perhaps more conspicuous in the
Asian context. Japan is one of the
few economies in the region where
companies appear to be available at
reasonable prices. In private equity deals,
enterprise values equivalent to more
than 10 times EBITDA are the norm in
hot markets, such as China, India, and
Indonesia. Japan provides a contrasting
picture with five to seven times EBITDA
and less than five times in buyouts of
small and medium enterprises (SME).
This difference is due to the high
prospects for growth in Asian markets
outside of Japan. Many research papers,
including one from PwC, predict that
by 2050 China will be the world leader
in GDP, with India and Indonesia
also among the top five (“The World
in 2050,” February 2015, PwC). Asia
already accounts for 60 percent of the
world’s population and is still growing.
Among the global middle class, which
is expected to reach 4. 9 billion by 2030,
59 percent will be Asian, according
to the Organization for Economic
Cooperation and Development (OECD)
(Kharas, Homi, 2010, “The Emerging
Middle Class in Developing Countries,”
Development Centre Working Papers,
NO. 295, OECD Publishing). Such
projections in general make investors
bullish about corporate growth in
the region, boosting valuations in
both public and private markets.
The low entry price in Japan reflects
the low public market comps. In
addition, in the SME space, there
are some arbitrage effects owing to
the weak focus on returns on equity
(ROEs) and less sophistication in the
intermediation between buyers and
sellers (Motoya Kitamura “Why is
Japan’s Mid-Market Buzzing?” BRINK
Asia, brinknews.com, March 2017).
Regarding the leverage effect, negative
interest rates have removed some
economic burden from companies.
In addition, banks in Japan tend to
behave less on a stand-alone deal
basis, as they historically have pursued
relationship banking. Therefore, for
companies with leveraged debt that
trip loan covenants, execution of
lenders’ remedies is often negotiable.
Back to Basics
Most tactics employed by buyout fund
managers to improve operations in
Japan should sound familiar to U.S.
readers: roll-ups, client introductions,
introduction of new store openings
valuations, introducing employee
valuation systems, selling noncore
businesses, expansion into new markets,
replacing CEOs and CFOs, streamlining
the supply chain, rebranding, improving
retail websites, etc. In turnaround deals,
the story should also be quite familiar:
fast and decisive action by turnaround
managers. These measures have more
or less been implemented already,
many of them quite impressively.
Since their market inception in the
late 1990s, buyout funds in Japan
have either started from scratch or
imported Western skill sets to boost
operations in portfolio companies.
Many of their investment professionals
were educated in the U.S. or Europe,
or have had career experience in
global buyout or consulting firms.
These professionals have picked up
best global practices and superbly
adopted them to the Japanese market.
The uniqueness of the Japanese
buyout market lies in its emphasis.
Generally speaking, there is more
focus on the basics, such as internal
operational improvement. This is more
evident as the deals get smaller or
as the investments are undervalued.
In the microcap space, for example,
some operational improvement
measures include introducing
As the deals get bigger or command
higher entry prices, the required
operational skill sets tend to become
more sophisticated. This is because
larger companies tend to already have
more sophisticated internal accounting,
compliance, and governance
procedures in place than their smaller
counterparts and because pricier
investments need more heavy lifting
to beat the entry price at exit. As the
number of participants in the market
increases, the competition becomes
fiercer, increasing entry prices and the
necessary post-acquisition skill set.
However, even in bigger deals the
operational improvements in Japanese
buyouts may look elementary compared
to those in more developed markets. One
reason for this is that smaller companies
and bigger enterprises are both run less
efficiently in Japan. Even in the public
market, profit margins have historically
been lower than in more developed
markets. The average net profit margin of
Japanese listed companies has improved
over the years, but only to the upper
3 percent range. This is considerably
lower than 9 percent-plus increase in the
Standard & Poor’s 500 index last year.
Even in bigger deals the operational improvements
in Japanese buyouts may look elementary
compared to those in more developed markets.