Since the bubble burst in the early 1990s the value of Japanese stocks have on average reduced by a third while U.S. stocks are up well over three times. What’s more, Japanese stocks now trade about one time book value compared with almost twice that for those in the U.S. By these measures, Japanese equities are undervalued. We asked Joji Takeuchi, CEO of Brightrust PE Japan, for his opinion on what it will take to unleash value from Japanese companies and what role Japan’s private equity (PE) funds could play in this regard. Brightrust is a Tokyo-based independent investment advisory firm.
According to Takeuchi, Japanese stocks have historically traded at a higher price earnings ratio (PER) compared with U.S. stocks. PER is a key measure of performance for listed stocks derived by dividing a company’s current share price by its net (after tax) earnings per share. A high PER usually means a stock is expensive. Takeuchi points out that Japan’s PERs have often traded higher in part because Japanese management have not given priority to maximizing net company profits. Though the situation is changing, Japanese shareholders have not applied strong pressure on management to maximize shareholder value. Rather, they have allowed management to generously accommodate the interests of other stakeholders, namely employees, clients, suppliers, and the management itself.
Takeuchi believes that high Japanese corporate tax rates have increased PER. “A company paying a 40% tax rate has a 14% higher PER compared to a company paying the 30% tax rate (about what the average U.S. corporation pays according to research by Morgan Stanley), even if their pre-tax earnings are the same,” said Takeuchi. Takeuchi thinks that higher tax rates have incentivized Japanese corporations to spend more money on long-term projects, sometimes unwisely. This has resulted in higher depreciation costs, which by the same logic drives up PER. “Japanese company shares are often cheap as a multiple of EBITDA,” said Takeuchi. (EBITDA is earnings before interest, tax, depreciation and amortization.) “This creates very interesting investment opportunities for Japanese buyout funds.”
Accordingly, Japanese PE funds are eyeing the “forgotten” small stocks which may be under-priced. “Few stock analysts cover them,” said Takeuchi. “The PE funds are trying to delist these companies to take them private so that they can purchase them, typically paying a 30%- 70% premium over the prevailing stock price.” Yet Takeuchi believes PE funds can still buy these companies at an attractive three to six times EBITDA multiple. “This is a very attractive price, substantially lower than those a U.S. or European PE fund would typically pay,” said Takeuchi.
If the investment opportunities are so great, why is Japan’s private equity not thriving? In truth, many Japanese PE funds are facing difficulties raising capital. After the Lehman crisis of 2008, banks around the world have been reducing their investment in private equity. Many are selling their holdings because of increased (tier) capital requirements under BIS II & BIS III and because of the Volcker Rule, both attempts by international regulatory bodies to prevent another financial crisis.
With foreign banks drastically reducing their leveraged buy out loan business (LBO) after the Lehman crisis, the Japanese banks found themselves dominating the domestic LBO market. “Banks that had previously invested in PE funds to secure LBO business realized there was no need to continue to invest in PE funds to secure that business,” said Takeuchi. “So they stopped investing.”
In addition to banks, PE funds have relied on Japanese insurance companies as a source of funding. After suffering the Lehman crisis and the triple disaster of 3/11, insurers have reduced their investment into private equity.
Although some corporate pension funds do invest in private equity, public pension funds have never done so. This compares with U.S. public pension funds that typically earmark about 10% of their portfolios into private equity. CalPERS, the largest U.S. public pension fund with $240bn under management, allocate about 14% of their portfolio to private equity, for example. There is no equivalent funding by public pension funds into Japan’s private equity.
Against this backdrop, Japanese PE funds turned to foreign investors. According to Takeuchi, raising funds from overseas investors turned out to be even tougher. “Japanese PE funds once were the preferred choice of foreign investors. Japan-focused private equity firms were profitably managing $0.5bn mid-sized funds in the early 2000s. These PE funds were making very attractive returns for investors and became even more popular when they raised subsequent funding rounds. For example, Advantage Partners and Carlyle ended up establishing $2bn funds in 2006/7. But it soon became apparent that it was far more difficult to successfully manage $2bn funds in the Japanese market.”
Too much money was chasing too few big deals. Brightrust has identified only about 340 listed stocks out of 2,400 on the Tokyo Stock Exchange with market caps greater than $2bn. Takeuchi explained, “To invest $2bn a PE fund manager would have to make about eight equity investments each in the amount of $200m – $300m.” Back then, buyout transactions were typically leveraged two to five times. This meant that each fund had to find two to three transactions sized $0.5bn – $1.5bn every year. But there were only a small number of sizable listed companies with $1bn businesses to sell. “How many $1bn transactions do you think a fund can buy without running into intense competition?” asked Takeuchi adding, “They struggled to find enough deals that were large and attractive. Some investments turned very sour.”
Takeuchi thinks fund managers were overambitious and investors should have expected that such large funds were bound to face problems. “Japanese companies are much smaller than you would think,” said Takeuchi. “For example, Takeda’s market cap is less than 1/5th of that of Pfizer’s or Johnson & Johnson’s. Kao is 1/12th that of Procter & Gamble’s. Sharp, a well-known Japanese brand, has a market cap of only $5.5bn. Seiko is merely worth $0.5bn.”
Once burned, foreign investors who had invested in Japan’s large PE funds before the Lehman crisis are now hesitant to return to the Japanese market. “Today, many investors clearly understand Japan is a market for small-mid cap buyouts, but they remain hesitant to commit investment to small-mid sized PE funds,” Takeuchi said. “They are now shunning low growth Japan in favor of higher growth China and India.”
As a result Takeuchi believes investors are missing opportunities. He concludes, “There are lots of small to mid-sized Japanese companies that have great products, services and technologies. These companies have remained small, partly because they have been under-managed. They need financial and managerial support to improve operational efficiency and profitability. Many wish to expand their overseas business. Japanese companies, including SMEs, are the greatest beneficiaries of China’s growth. But they lack resources and networks.” Takeuchi believes Japanese private equity could unleash that value, if only they could raise the funds.
Joji Takeuchi is CEO of Brightrust PE Japan Co., Ltd. Brightrust is a Tokyo-based independent investment advisory firm. www.brightrust.jp