The Evolving State of Play for Japanese Private Equity

Rising competition among foreign and domestic private equity firms is creating a thriving mid-market sector – offering local fund managers a chance to shine for global investors

In recent years, the expansion of the global private equity & venture capital (PEVC) industry has benefited greatly from the acceleration of technological innovation, carve-out activity, and consolidation opportunities. As Western private capital markets have matured on the back of these trends, fund managers and institutional investors have increasingly needed to look further afield for attractive yields. In a short period of time, Japan has emerged to successfully meet part of this need and become an important locale for rising capital flows into Asia-Pacific.

PEVC industry assets under management (AUM) targeting Japan stand at a record $68bn as of December 2020 – more than double the total just three years ago – highlighting ample demand from investors in the asset class. Part of the appeal has been the strong risk/return profile offered by fund managers: PEVC funds focused on Japan boast a robust median net IRR of 21.0%, with a standard deviation of less than 12% across 2008-2018 fund vintages, according to Preqin data. What’s more, a study by the Japan Private Equity Association looking at buyout funds in isolation found its members have recorded an annualized IRR of 18.2% over the past five years (2014-2018), and 12.6% over the past 10 years (2009-2018).

The other part of the equation is that the domestic private equity market is evolving for the better, offering more opportunities for deployment that were either previously inaccessible or simply not yet ready to be leveraged for value-creation activities. Indeed, we believe the growth momentum experienced thus far is only getting started.  

Deal Activity Is Becoming More Dynamic
The Japanese buyout market has been exceptionally hot this year, with blockbuster announcements involving homegrown mega-cap enterprises such as Toshiba and Hitachi Metals being pursued by notable international PE funds like CVC and Bain. In H1 2021, private equity-backed buyout deals recorded almost $13bn in total value – a sum already 44% higher than all of 2020. High-profile carve-out activity is shining a spotlight on Japan’s PE industry, where foreign PE firms have been playing a larger role in recent years, and is encouraging more participation.  

The pick-up in buyout activity makes sense. Japan is at an important inflection point where the primacy of corporate governance, shareholder activism, and value creation among listed enterprises is taking center stage – a long-awaited moment for the domestic capital market. Private equity firms serve as a conduit for change and are well positioned to mobilize transformation initiatives for value creation. As activism continues to rise in Japan and regulatory pressures push for the reduction of stagnant cross-shareholding arrangements, private market players will stand to benefit from more deals.

Family-Owned Businesses: A Missed Opportunity
While headline-capturing mega deals drown out market commentary, we must not forget the significant market for buyouts in the SME segment (family businesses) which is growing on a wave of succession opportunities. It is estimated that around half of the 2.45 million SMEs with managers aged 70 or older are expected to be without successors by 2025. This trend has been accelerated by COVID-19, which has spurred many family business owners to reevaluate their priorities in life and plan to step down earlier than they otherwise would have.  

The succession cycle is headed for a once-in-a-lifetime peak which will offer investors a clear and largely untapped lever for return enhancement. That said, actively participating in this opportunity is not an easy feat. For one, Japanese owners can face a 55% marginal inheritance tax rate, which requires complex liquidity management and intergenerational mediation with a trusted partner to navigate.

Second, these businesses have highly involved stakeholders which include key suppliers, concentrated B2B customer relationships, employees protected by extensive labor laws, and banks – all of which care who owns the company long term. Lastly, they require extensive improvements to rationalize operations and governance processes in a way that respects traditional business customs and expectations. A good example from our portfolio was our acquisition of Tokyo Denkai, a specialist tantalum metal refining company, with a 50% global market share. The deal required close strategic coordination with key offtake customer JX Nippon Mining & Metals Corporation.  

Taken together, all these issues require on-the-ground knowledge and a successful track record managing sensitive challenges. While this means deals can take time to manifest, doing things the right way can deliver outperformance. As a member of a public listed investment group, Mercuria has been able to establish a reputation of trust among business owners, capturing 2.9x in gross multiple on invested capital (MOIC) and a gross IRR of 56.3% from realized deals for our first buyout fund in the process.  

The Future of Family Business Is Global
Despite the difficulties, these businesses possess unique technology, expertise, and services with very healthy balance sheets. In addition, we target specialized B2B industrial companies that provide necessary equipment or solutions where fundamental cash flows drive valuations. Although not as sensational as high-tech growth start-ups, they are stable, offering a competitive risk-adjusted return while also satisfying our 5-7x EBITDA entry target.  

Beyond the more obvious operational and governance improvements, key to our approach has been a core focus on developing a clear internationalization strategy. Family businesses have traditionally been over-reliant on a few domestic ‘keiretsu’ clients and lack experience in scaling marketable products cross border and growing corporate partnerships. In our 20+ years of working internationally with Japanese companies, capturing this opportunity is a low-hanging fruit with immediate benefits to the bottom line.  

To execute on this value-creation lever requires building a global network of strategic partnerships and establishing a local presence, which is not easy to replicate. Mercuria has additional teams in Beijing, Hong Kong, and Thailand that have helped countless

investee companies such as aluminium precision manufacturer Mizutani and industrial machinery company Shinx to enter new markets, as well as expand product portfolios via international linkages.  

What’s Next for the Local Private Equity Industry?
Despite the challenges faced during the pandemic, competition is heating up among foreign and domestic fund managers in Japan. Deal activity is being fueled to new highs as substantial amounts of capital flow into the country. Private equity firms headquartered in Japan have been successfully fundraising throughout the past year, while large overseas firms have also picked up the promotion of buyout strategies targeting the Japanese market. This means fund managers will likely need to work harder to secure attractive deal opportunities and unlock returns to stand out. But it also sets a solid foundation for a more dynamic deal environment, where skilful capital deployment can benefit.  

Aside from more capital coming into the asset class, the investor base is also becoming more diversified. Attention from international investors who recognize the untapped potential of the local buyout market and the viability of having larger private equity allocations focused on Japan is much higher than previous years. The benefits are already noticeable. Domestic fund managers, Mercuria included, have witnessed a marked increase in investment inquiries from overseas allocators such as endowments and family offices – we expect this trend to continue. Now that our 2016 buyout fund has been mostly deployed, our own fundraising plans for the launch of our second fund will look to leverage strong existing and new relationships with domestic investors and a few selective commitments from new international allocators. 

About Mercuria
Mercuria Investment Co., Ltd. (MIC) was established in 2005 with Development Bank of Japan as a main sponsor. The firm was listed on the Tokyo Stock Exchange in 2016. In July 2021, Mercuria Holdings Co. Ltd. was established and listed on the Tokyo Stock Exchange (code: 7347), transitioning to a holding company structure. MIC specializes in cross-border alternative investments, making investments in both private equity and real assets. Notable investments include Lifenet Life Insurance, Spring REIT, SONOKO, Izumi Seiki, and Mizutani Industrial Group.