Prospects of Private Equity Funds in Japan - Expectations toward Finance with Ideas and Commitment
AUTHOR
Kazuaki Washimi
Director
Bank of Japan
Changing Environment Surrounding Japanese Firms
Japanese firms have faced the need to adapt to globalization, digitalization, and post-COVID-19 economic structural changes against the headwind of a declining population. Japanese firms have reduced liabilities and raised their capital adequacy ratios since the late 1990s. This capital accumulation could increase resilience against crises and has in fact contributed to a relatively smaller number of corporate defaults in Japan during the current COVID-19 crisis. Nevertheless, the question of whether a majority of Japanese firms have made effective use of their accumulated capital as risk capital for business reforms remains open. This could be consistent with a slower growth of TFP (total factor productivity) among the components of potential growth in the Japanese economy.
Meanwhile, the aging of CEOs has progressed remarkably in Japan and the need for business succession is growing. In particular, the effects of COVID-19 are expected to increase the need for corporate restructuring in an even more severe business environment. Business reforms will be inevitable in order to increase business growth prospects and sustainability.
In this context, impending corporate restructuring could be a good opportunity to implement business reforms that have been postponed until now. For this purpose, CEOs and shareholders who can take decisive action are needed. Here, private equity funds (PE funds) are considered a vehicle that can provide such a function.
PE Fund Investments & their role in Business Restructuring
PE funds correspond to investment funds that mainly invest in unlisted shares. Buyouts—the acquisition of a controlling interest in a company by buying shares—account for the majority of PE deals, where a company is bought out with funds from investors and added value is provided to the acquired company. In general, PE funds hold the shares of acquired companies for about 4-5 years on average, and then sell those shares to non-financial corporates or exit through an IPO. In recent years, due to increased awareness of capital efficiency and the aging of CEOs, the number of buyouts by PE funds in Japan has increased led by carve-outs and business succession-oriented deals reflecting a need for further corporate restructuring.
The benefits of PE fund investments include the fact that firms can make strategy and action plans for 10 years into the future as PE funds make relatively medium- and long-term commitments to management and firms can reinforce their management structures and governance using the management resources of PE funds (e.g., human resources, management know-how).
The deal value per year in Japan’s PE market has picked up, chiefly led by large deals in recent years. Nevertheless, compared to the U.S. and Europe, the market size of PE in Japan remains small in terms of the percent of nominal GDP. The history of Japan’s PE market is also short relative to the U.S. and Europe and track records of deals are rarely available. Therefore, empirical analyses on the impact of corporate restructuring via PE funds have been extremely limited. That said, the Bank of Japan staff anlaysis together with very recent studies indicate that corporate restructuring by PE funds in Japan is expected to increase the value added per worker by increasing sales without reducing the number of workers on average. While care should be taken in interpreting those studies as the results could vary across firms and countries, this might reflect the fact that investments by PE funds have increased added value by not only reducing costs but also improving the business efficiency of the investment targets (e.g., promoting globalization and digitalization, reform of supply chains and organizations). Expanding these investments could lead to improved productivity in the Japanese economy. To achieve that, at least the following three challenges need to be addressed.
Challenges for the Expansion of PE Funds
First, it should be noted that the level of awareness of the benefits that PE funds could bring to the economy needs to be improved in Japan. Once social recognition has improved, it is likely the number of PE deals from CEOs and shareholders (who consider business succession and sales of the business) to PE funds will increase. That could also contribute to attracting funds from investors that focus on sustainable investments. As can be seen in other countries, data accumulation and increasing transparency with respect to PE fund investment performance and portfolio companies are key.
Second, institutional investors—both domestic and foreign—could further expand investments in PE funds in Japan. Until now, while pension funds account for about a quarter of PE investments globally, pension funds comprise around only 10 percent of PE investments in Japan. It would be worth considering investments in PE funds as an alternative investment as the performance of domestic PE funds for 2009–18 was greater than the return on domestic equity. As discussed in previous literature, institutional investors seek consistency in accounting standards on mark- to-market valuation together with a shift to fair value based valuation with respect to PE investments. It is therefore expected initiatives on fair value based valuation across funds will progress.
Third, professional human resources in business restructuring need to be maintained and further developed. Industry stakeholders have noted that the difficulty in coping with the increase of investments lies in maintaining not only those who have technical skills in finance such as business valuation, but also professional managers who can increase corporate value and lead companies after PE investments. Given the size of the business community in Japan and the business restructuring in each sector, there should be a certain number of potential candidates who can be professional managers. However, it appears that matching those potential candidates with firms that need managers has not necessarily been effective. There is a need to further improve services in this area.
Conclusion: Now is the time
It has been said now is the time for a ‘Great Reset’ around the world in the wake of the pandemic. Going forward, Japanese firms need to embark on business reforms in order to adapt to structural changes including globalization and digitalization. PE funds—finance with ideas and commitment—are expected to play a pivotal role in reigniting Japan’s growth through promoting structural reforms in the economy. For Japan Inc., now
is the time to “sail away from the safe harbor2” and set sail to catch the winds of change.
The opinions expressed here are those of the author (based on the Bank of Japan Research Paper released in December 2020) and should not be ascribed to the Bank of Japan.
Published 2021