Investing in Japan: Promoting Innovation & Facilitating Changes

May 1, 2013

Haruyasu Asakura
, Chief Operating Officer, the Innovation Network Corporation of Japan (INCJ)

Louis Forster
, Senior Managing Director, Cerberus Capital Management, L.P.

Haruyasu Asakura, COO of the unique public-private investment fund Innovation Network Corporation of Japan (INCJ), visited Japan Society to discuss INCJ's business philosophy, investment results and future outlook.

When Mr. Asakura joined a private equity fund in 1999 after a decade and a half at Mitsubishi, it was a time of immense optimism about the private equity business in Japan, he said.

Private placement memos written for prospective investors trumpeted the "huge potential" of investment in Japan. They cited Japan's position as the world's second-largest economy, its low country risk, sophisticated social and business infrastructure, and highly developed technology base. They stressed the opportunities for consolidation and the ready availability of cheap debt.

Private equity in Japan enjoyed a boom from 1999 to 2006 or 2007, but after that came disappointment. "If we look at the PE business market, Japan's penetration ratio is extremely low," only 0.04 percent of GDP, Mr. Asakura noted. There's been almost no growth in corporate Japan during the past decade, and market capitalization for Japanese companies right now is very low.

Over the past 20 years, Japanese companies starting out in a product market have done very well, but when the market expands, they "very quickly lose market share," he said. Rather than challenge their competitors, they seek out yet another small, growing market. Companies end up being over-diversified, and industry structure is highly fragmented.

By contrast, "if you look at strong contenders in the global market," companies like Toyota and Samsung, "they always take a focused strategy."

"Why do Japanese CEOs make the wrong choice on diversification?" The answer lies in the "huge external pressure to choose low-risk/low-return alternatives," pressure that comes from lenders, from the parent company, the government, industry associations, even labor unions.

"Japan has very cheap debt. This is a good thing and a bad thing," he said. Bank loans represent 40 percent of corporate financing in Japan, versus only 10 percent of corporate finance in the U.S. Having an ample source of cheap money is great, but the problem is that the banks aren't willing to lend on risky ventures—which "drives the company to take lower-risk/lower-return alternatives."

Equity financing in Japan got a small boost during the PE boom, but declined again after 2007. "The corporate control market is still immature in transactions, volume and number of transactions—it is very limited compared with the U.S. market," Mr. Asakura said.

"It is very difficult to start a new business, and it is very difficult to stop money-losing businesses as well." Employment turnover is low, despite Japanese government efforts to alter some aspects of the employment system.

Distressed situations and owner-managed assets are exceptions, but "the vast majority of the larger assets at this moment are untouched by the major PEs."

The Goals of INCJ
The Innovation Network Corporation of Japan, or INCJ, was founded three and a half years ago and has an investment capacity of $20 billion. The firm, which has an investment team of around 70 people, is set up to have a limited lifetime of 15 years.

INCJ to date has committed about $6 billion in some 39 transactions. Unlike an ordinary PE firm, it's a public-private partnership, raising most of the money it invests from the government. "At the same time, our investment practice is very, very commercial," and the firm's investment decisions are "completely independent," Mr. Asakura said.

Structuring, due diligence, governance and many other aspects are handled much the same as with an ordinary PE firm, he explained. "But our purpose is that after we make an investment, we like to create long-term competitive businesses in our country." If INCJ is successful, "we hope that more global LPs and more global GPs get interested in the Japanese market" and decide to co-invest with limited partners and general partners in Japan. "That will result in a risk-money cycle, and also at the end we can create an equity culture in our country."

In contrast to the typical private equity fund, INCJ's focus is "on the growth of the business rather than cost reduction or deleverage." The firm aims for a holding period of five to seven years, which is longer than the typical PE investment period. The INCJ decision criteria include a "value impact" element, unique to the firm, which is conceived of as "long-term economic impact beyond the investment horizon."

Though INCJ's government ties are "very effective when we try to change a CEO's decision," investment decisions are made independently and are "very much focused on value and economics," he added.

The firm's major investments to date have been in the electronic devices and life sciences sectors, with expansions planned into materials, chemicals, and IT business infrastructure. INCJ invests both domestically and internationally, though in the latter case "we always tie up with a Japanese corporation," Mr. Asakura said.


Moderator Louis Forster of Cerberus Capital Management began the Q&A:

Is the culture of risk aversion fostered by Japan's executive compensation structure? Would adopting a system that more directly rewarded management based on results rather than seniority change the risk-taking ability of senior management?

"In the day-to-day negotiation with the CEOs, they are more concerned about accord within their society rather than [their] personal motivation. So, that is why compensation is very important, but compensation alone cannot change their minds," Mr. Asakura replied.

Audience members joined the discussion:

Do you mostly staff the portfolio investments with Japanese nationals, or do you bring in outside foreign managers?

INCJ's staff includes a non-Japanese member in the portfolio support section, Mr. Asakura said. "Within our portfolio, there are several non-Japanese CEOs and we very much actively recruit non-Japanese people, because one of the challenges of Japanese companies going forward is globalization."

Are you free to pursue investment policies that might contradict government policies?

The firm's investment board is "very independent," and assuming a target is viable from an investment perspective, "we can do some investment even if that particular transaction is not 100 percent following the government's industrial policy"; examples include investments in renewable energy.

With the level of innovation and creativity in Japan, is that playing into delivering private equity into the startup space?

INCJ is looking at startups, "but it is very difficult to replicate Silicon Valley in Japan," Mr. Asakura said. Just as Silicon Valley and other parts of the U.S. have different styles in promoting entrepreneurship, "we like to encourage entrepreneurship in general, but more like a Japanese way of encouraging entrepreneurship."

There's no counterpart under Japanese law to the tax-free spinoff in the U.S., which has been a source of deal flow for PE firms when shareholders decide to sell off their positions. Would tax law changes along these lines have an effect on deal flow in the Japanese market?

This could have a positive impact, Mr. Asakura said, "but on top of that we need to create an equity culture in our country." It's "more like society as a whole that needs some changes."

What will be the source of funding for private equity investment in Japan—mostly from internal sources?

Eventually "we have to create an investment cycle—Japanese money going to the Japanese company. That is the final scenario. Up until that time we have to invite non-Japanese investors into our country, because investors are more sophisticated outside of Japan. And if we can convince them to make an investment in Japan, maybe Japanese investors will also follow."

A question for both of you: What's the trend for private equity in Japan in the next five or 10 years, and which sector needs private equity involvement the most to spur growth?

Electronics and chemicals have serious equity needs, Mr. Asakura said. So does the auto industry, aside from Toyota, which is doing OK. Auto component makers depend heavily on OEMs and have to have funding to change that pattern. Healthcare and pharmaceuticals need equity funding for R&D and to handle regulatory changes.

Consumer retail, IT and business services sectors "are a little bit low-risk/low-return business, so bank finance is still functional. But if they want to become global companies, they definitely need more risk money," he added.

Mr. Forster noted that Cerberus made its first investments in Japan in the distressed area. The analogy is emergency room medicine: it's high risk, you lose patients a lot, and only a small number of doctors choose this as a career. "So, there will always be a place for a foreign private equity player focused on a Japanese distressed company."

Another area that Cerberus sees as "very promising is reservoirs of technology in Japan that should have much larger foreign markets," Mr. Forster added.

This needn't be cutting-edge technology. "There are many, many manufacturers who do something better than anybody else and they don’t have any foreign markets," he pointed out. Take a very small Japanese company that makes wonderful umbrellas, "about the best umbrella in the world." The company has not pursued a U.S. or European market. With private equity backing, it could do so and take on less risk than going it alone, and with a lot less expense than using a big Japanese trading company.

What are the most significant challenges INCJ is facing?

"Probably the independence of investment decision," Mr. Asakura replied.

"Government affiliation is a very, very powerful tool to change the CEO's behavior. At the same time we have to make very independent decisions. Otherwise, if we receive too much influence from politics and the government side, it is very difficult to make commercial decision making."

How do you handle the post-investment phase with your portfolio companies?

INCJ has a specialized team that works on post-investment issues, Mr. Asakura said. "What we are doing is very similar to a typical private equity fund"—seats on the board, close communication with CEOs, active involvement in the portfolio company's key strategic decisions. INCJ also devotes a lot of time to building industry-focused networks that serve as resources for the firm and its portfolio companies.

—Katherine Hyde

Topics:  Business

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