Private Equity’s Next Opportunity: Seeing Japan through the Eyes of Richard FolsomMay 14, 2014
Richard Folsom, Representative Partner, Advantage Partners, LLP
Daniel Bases, Correspondent, Thomson Reuters
On May 14, 2014, Richard Folsom of Advantage Partners shared with Japan Society his thoughts on what's ahead for the private equity business in Japan.
Mr. Folsom first came to Japan as a very young man, just out of high school and serving for two years as a Mormon missionary. Back in the U.S. for college, he chose a double major in economics and Japanese. He graduated in 1984 and got a job with Bain & Company's new Tokyo office. Except for a short time in the U.S. studying at Wharton, he's been in Japan ever since.
In 1992 he and Taisuke Sasanuma, a colleague from Bain, started their own firm in Tokyo, Advantage Partners. They had in mind a private equity model pioneered by Bain Capital, the Bain & Company spinoff founded by Mitt Romney. Japanese law, however, "pretty much made it impossible to do private equity as we wanted to." Financial shareholders could not own a majority of an operating company, and couldn't be involved in management.
It was a year or two after the bursting of the economic bubble. Structural reforms, deregulation and other remedies were being heavily debated. Finally, in 1997, legislation was passed to permit majority ownership and active participation with management. "We went out to raise what became the first buyout fund in Japan," partnering with Marubeni Corporation.
Abenomics has already produced successes in multiple areas, Mr. Folsom noted: significant growth in the BOJ balance sheet; an exchange rate at 102 yen to the dollar, up from 80; equity markets up by some 40 percent; and inflation at 1 percent, half way to the 2 percent target for next year.
Corporate and consumer confidence "is markedly changed from what it had been over the last two decades." Government spending is up. Companies have been persuaded to raise wages and salaries by more than 2 percent this year, the largest increase in 16 years.
Tokyo's selection as host of the 2020 Olympics has brought Japan "a lot of positive confidence and psychology." After so many years of short-term governments, there's a feeling that Abe could be the prime minister who ushers in the Games, a symbol of "stability and continuity."
The structural reform aspect of Abenomics, the "third arrow," isn't a single-shot arrow but "a thousand needles," as a friend who is an economist puts it, Mr. Folsom said. "Having continuity to see that through over a three- to five- to six-year period going forward is going to be critical."
The Overall Economy
"The overall economy is not completely out of the woods," Mr. Folsom observed. "Export volumes have not turned around or grown to the extent expected" with the weaker yen. "I think there is fundamentally an issue with the competitiveness of Japanese corporations on a global basis"—Sony and Panasonic being "poster children for this in the media." As large companies in Japan adapt to these realities, "potentially investing in corporate carve outs" becomes "one of the opportunity sets for private equity."
Fiscal Concerns. "Foreign equity investors remain concerned about the fiscal situation," he said. "So far in the current year [corporate] earnings are up significantly, and the tax base has increased," as the Abe administration had hoped. "The question is can that sustain itself over a period of time to make a significant dent in the debt."
Geopolitics. The geopolitical situation in North Asia "does have a real impact on corporate behavior and corporate sentiment... It’s probably a reality that it’s going to persist for the rest of my active investment career. But it’s just something that we have to find a way to get comfortable with and deal with."
Demographics. To address Japan's aging demographics, the Abe government is exploring policies on women's participation in the workforce. Raising the age at which Social Security benefits begin "now looks like it’s becoming part of the discussion" in the government—interesting especially in light of Australia's having raised the Social Security age to 70 or 73, versus 63 or so in Japan. Immigration policy is another important arena.
Private Equity Opportunities
2013 was a busy and successful year for his firm, Mr. Folsom said. The improved public market environment enabled Advantage Partners to exit eight of its 17 or 18 active portfolio investments, as well as to make four new investments.
Exits. "When you talk M&A with Japanese corporations, it almost always implies buying, and seldom implies selling. We try to preach the gospel that it’s both.... But that is still slow to come in some sense."
Markets. The environment is a good one for helping portfolio companies to boost earnings, "getting some level of top-line growth both domestically, but also helping companies to access... and develop overseas markets."
Deal Flow. Major drivers of deal flow this year are expected to include corporate divestitures and founder succession, the latter partly for estate planning purposes and partly "for transition to professional management," Mr. Folsom explained. Owners see the upward market trend as a signal that they can get an appropriate valuation if they sell.
Secondary buyouts, that is, buying from other funds, will also play a role. Public to private deals may see "a little bit of slowing this year," and restructurings and special situations will be "a little bit more cyclical."
Performance of Portfolio Companies
"We pride ourselves on the fact that our portfolio in aggregate has significantly outperformed the market," Mr. Folsom said. The portfolio didn't experience "the same level of declines in the downturn," and achieved "a stronger uptick in the current market environment, with our portfolio companies projecting an even higher level of growth in the current environment."
"We attribute that to maybe a more intensely focused drive to make sure that we’re getting the most in terms of profit margin, cost control and going after whatever marginal topline revenue opportunities there are, and doing that in a more intensified fashion than your average company in Japan has done. The result is a significant difference."
Changing Attitudes Towards M&A and Buyouts
Historical barriers to M&A and buyouts in Japan have lessened in several areas, he said—"the cultural perception of M&A being very negative, the stigma of selling out... the lifetime employment legacy, also meaning that ownership doesn’t change hands either."
Many cross-shareholdings, by their nature conducive to "a lack of focus on shareholder value," have been unwound. In 1990 they were 30 or 35 percent of the market; today, less than 10 percent. "The slack has been taken up by foreign shareholders, which was 5 or 6 percent and is now 25 percent of the market cap in Japan."
Mid-1990s deregulation in Japan not only made private equity possible, but also "has led to the mobility of human capital." Layoffs and factory closings have "become acceptable and commonplace"; "responsiveness to performance incentives, and more entrepreneurial opportunities have emerged as well."
M&A activity in Japan was flat in 2010-11, in reaction to the financial crisis. Deal volume is still five or six times higher than in the mid-1990s, and Advantage Partners expects it to pick up again. Private equity buyers are between 10 and 25 percent of M&A deals in North America and Europe but no more than 3 or 4 percent in Japan; "to us that says that private equity activity still has room to grow." With "more and more success stories getting into the media," corporate sellers and founder/owners will continue to become more comfortable with these transactions.
"Our focus has been, and continues to be, on [the] mid-market space. But there still is expectation that eventually we’ll see more of the corporate sellers," Mr. Folsom said.
"Yes, there has been a private equity market that has emerged and evolved," Mr. Folsom said. "The current Abenomics environment is positive" for the evolution of the private equity market in Japan. "But there are other things that private equity has in front of it in terms of overcoming issues in terms of perception, and more players potentially entering the market and helping drive penetration, which is where the real opportunity for private equity is."
Daniel Bases of Thomson Reuters, who presided, began the Q&A:
Talk about how you view the impact of carve outs on the overall economy.
"There are lots of them potentially there; they just haven’t emerged," Mr. Folsom said. Companies like Sony and Panasonic want to "regain their competitive stature globally," and to do that, they "need to focus on key areas where they’re going to invest more resources than any of their competitors, in terms of next-generation product technology, manufacturing technology, manufacturing sites."
Carve outs help the seller devote more resources to its core assets. Meanwhile, the business that's sold gains "a shareholder that is single-mindedly focused on that business and how they can best make that business competitive. That in itself I think would be positive for the overall Japanese economy."
In the next three to five years, which sectors will see the most activity?
"There will be a shift from industrial export-based businesses to more service sector industries and businesses." Advantage Partners has been doing transactions in consumer services, especially retail, food services, restaurant businesses, business services. Another growth area will be health care-related businesses, "things that cater to and provide value-added services to the aging population."
The audience joined in:
Japanese companies are good at outbound investment, but what about inbound investment by foreign companies?
That's "still very limited," Mr. Folsom said. Where a private equity firm buys a Japanese company and later exits that investment, the ultimate buyer may be a foreign company. In this sense private equity may be able to facilitate more foreign inbound acquisitions in Japan.
How practical is it for the likes of Panasonic and Sony to spin off divisions given the cross-collateralization of those divisions by the banks?
"Many times it is the banks that are also trying to encourage" the divestiture, and will get some repayment of the debt out of the deal proceeds, he said.
What is the investor appetite for funds based in Japan and doing deals in Japan?
It's strong, Mr. Folsom said, in part because investors who feel they may be overallocated in China are looking to "more developed Asia, which really turns out to be Australia, Korea and Japan," for "this year and next year, and maybe a little bit beyond that."
I'm wondering about globalization culture in Japan. Do you see progress, for example more use of English in the companies?
"Language admittedly is sometimes a barrier in Japan for foreign operators. For foreign investors, they don’t necessarily need to be involved directly. We just need to be the translators of information that we provide to our investor base, and I think we’ve done a reasonably successful job at that."
"When we do our business with the Japanese companies, it’s all in Japanese—all of the documentation, all of the internal communication—because that’s what those companies, the management and those employees are going to be most effective at. It would seem artificial and inefficient to try to impose something other than that on a management team or a company."