With global private equity investors falling out of love with a misfiring China, and other Asian alternatives coming up short, Japan has become the region’s new PE darling, bolstered by favourable monetary policies and government initiatives, market and regulatory reforms, and its unique socio-economic development. And lawyers are bullish about the country’s PE activity going into 2024.

 

Japan has emerged as the latest hotspot for private equity (PE) investment as geopolitical risks and weak return outlooks dampened the attractiveness of other traditional Asian markets, amongst them notably China.

The Japanese private equity market saw deal activity of $25.1 billion in 2023 through 155 completed deals, according to research from Willis Towers Watson. These included the $15.2 billion buyout of electronics giant Toshiba by a consortium led by private equity firm Japan Industrial Partners.

Indeed, in a year where prolonged interest rate hikes severely impacted debt capital markets and brought global dealmaking to a standstill, Japan largely bucked the slump and saw a continued increase in mergers and acquisitions (M&A) activity, including private equity M&A.

“Private equity has continued to enjoy the Bank of Japan’s ultra-loose monetary policy, providing ample liquidity and low financing costs,” says David Azcue, a Tokyo-based partner at Simpson Thacher & Bartlett. He is also co-head of the firm’s private funds practice in Japan.

“It is also worth noting that Japan has long had among the lowest M&A penetration among developed economies, leaving significant room for growth,” Azcue adds. And compared to other developed markets, relatively low EBITA multiples have also helped boost Japan’s allure for PE investors and stimulate capital inflows, he observes.

Randy Laxer, a partner and co-head of Asia private equity practice at Morrison Foerster’s Tokyo office, underscores the strong U.S. dollar, the weak Japanese yen, and the low corporate valuations as amongst a range of factors contributing to this emerging trend.

“Major international private equity sponsors have responded to these favourable conditions by launching new funds specifically tailored for Japanese investment and expanding existing operations and fundraising activities in Japan,” notes Laxer, adding that Japan has fewer obstacles to foreign investment than certain of its Asian neighbours.

DOMESTIC DRIVERS

Stepping into 2024, economists are overall bullish about Japan’s equity markets, banking on the country’s expected exit from deflation, continued fund inflows and resilience valuation, as well as structural market reforms.

Although the global macro environment has played a crucial role in reshaping Japan’s ‘investibility’, official policies and changes from within the Japanese society have proven pivotal in accelerating PE-backed deal flow.

“Government initiatives in recent years, including the 2019 Fair M&A Guidelines, the 2022 Tokyo Stock Exchange (TSE) market restructuring, and the 2023 Guidelines for Corporate takeovers, coupled with a rise in shareholder activism, have sharpened Japanese companies’ attention to stock performance, portfolio rationalisation, capital costs and profitability,” notes Azcue.

Specifically, Laxer points out that “the TSE and activist investors continue to pressure Japan-listed companies to increase price-to-book (P/B) ratios above one, which means increasing market capitalisation to a level above net book value. As a result, an increasing number of TSE-listed public companies are exploring opportunities to carve out non-core assets and increase shareholder value.”

In response, “we have seen an increasing number of management teams of listed companies exploring management buyouts, as a means of implementing structural reforms, and turning to PE firms to sponsor and/or financially support these buyouts. Management and PE firms see investment in these companies, with low P/B ratios, as an opportunity to unlock value and realise investment returns,” notes Laxer.  

In addition, Japan’s rapidly ageing population has sent the succession plans of SMEs – representing more than 99 per cent of Japan’s corporate enterprises - to a tailspin, with many founders either childless or without an otherwise viable successor. Consequently, focuses on labour shortages, succession planning, and new management have created opportunities for PE-backed acquisition and investment opportunities.

“PE has helped fill this need by providing a mechanism for founders to ensure not only the succession of their businesses, but the institutionalisation and expansion of these businesses through access to capital, managerial talent and business options that many founders may not have conceived on their own,” explains Azcue.

With Japan’s birth rate continuing to stay low and the baby boomer generation inching closer to retirement, both Azcue and Laxer believe that business succession issues will persist as a source of PE investment opportunities.

FULL STEAM AHEAD

As there are signs that more PE firms are expected to enter the Japanese market, Azcue believes new entrants will mainly come from two places: Global PE firms expanding into the country, and spinouts from existing domestic players.

Understandably, global PE investors are drawn to Japan for large-cap investment opportunities with a lower risk profile, compared to other countries that fall short in terms of either market scale, investment appetite, or room for growth. But it is equally important to note the internal evolution of the PE industry in Japan itself, lawyers say.

“There has also been a natural diversification that comes with a maturing industry, with significant focus for domestic firms on venture capital (VC), real estate, infrastructure - including renewables and logistics - credit, secondaries and GP stakes,” says Azcue.

“The factors driving these trends are likely to carry into the near- to medium-term future, with the caveat that firms are constantly evaluating the significant volatility in the environment, and that any escalation of regional tensions, regional or global pandemics, or economic crises could quickly shift the calculus,” he adds.

While both Azcue and Laxer agree that the real estate sector is one of areas registering robust momentum, Laxer also sees PE deals in life sciences and healthcare being hotly sought after, driven by “both innovation and sector consolidation.” Azcue highlights infrastructure and private credit as the ones to watch.

Moreover, Azcue notices interest in GP-led secondaries and VC investment, although VC deals in Japan have experienced a slump amidst downward pressure globally, according to data from Pitchbook.

 

“Barring significant shocks, the outlook remains strong. The underlying fundamentals are likely to remain consistent, with low EBITDA multiples, cheap debt and a weak yen making investments attractive economically, continued effective government support for the PE industry through smart policies, continued growth and acceptance of private equity M&A, and increasing interest from international players.”

- David Azcue, Simpson Thacher & Bartlett

 

Retail strategies also come under the spotlight, as “large global sponsors continue to seek new distribution channels for alternative investments, and Japan represents a large and fairly well-developed market, with a critical mass of high-net-worth individuals and potential retail investors,” says Azcue.

Looking ahead, lawyers strike an upbeat tone. “As a general trend, we expect that lower interest rates, the high volume of dry powder on the PE/debt fund side and the return of bank risk appetite will lead to a significant increase in M&A activity during 2024. While we expect this to be a global trend, Japan is well positioned to benefit from this uptick in deal activity and availability dry powder,” says Laxer.

Azcue concurs. “Barring significant shocks, the outlook remains strong. The underlying fundamentals are likely to remain consistent, with low EBITDA multiples, cheap debt and a weak yen making investments attractive economically, continued effective government support for the PE industry through smart policies, continued growth and acceptance of private equity M&A, and increasing interest from international players,” he says.

Furthermore, “many of the larger domestic fund sponsors appear set to come back to the market and push for new fundraising records, increasing diversification of asset classes and continued growth in deal volume,” adds Azcue.