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The Role of Buyout Funds in Accelerating Business Recovery in Japan1

  • 1 This was prepared as an article, which originally appeared in INSOL WORLD, Winter 2003.

February 2003
Makoto Ohsawa

Papers in the Financial Markets Department Working Paper Series are circulated in order to stimulate discussion and comments. Views expressed are those of authors and do not necessarily reflect those of the Bank of Japan or the Financial Markets Department.

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The Japanese government's comprehensive package to accelerate financial reforms in October 2002 was seen as a highly significant landmark for two reasons. First, this program is the official confirmation of the government's view that Japan will not be able to escape from the slump which has plagued its economy since the bursting of the financial bubble without resolution of the problems related to the nonperforming loans. It set a clear numerical target for the reduction of such loans as well as concrete methods to achieve it, such as rigorous reassessment of banks' assets employing discounted cash flow analysis. Second, it was the government's first official acknowledgement of the importance of business recovery, an issue inseparable from the bad loan problem. It embodied the government's three major commitments, namely creation of the Industrial Revitalization Corporation, compilation of guidelines for early business recovery, and an overhaul of the Industrial Revitalization Law.

Japanese firms depend heavily on bank loans (more than 60 percent of corporate borrowing is from banks) and thus, it is often the case that banks take the initiative in business recovery. Markets, however, have not always given them high marks for their performance. Consequently, the focus is being placed increasingly on the role to be played by buyout funds and nonbank financial institutions in speeding up business recovery. It is against this background that the Japanese Association of Business Recovery (JABR) and the Bank of Japan held a joint seminar titled "The Role of Buyout Funds in Business Recovery in Japan" in September 2002. At this seminar, Mr. Andrew Lebus, Managing Director of Pantheon Capital (Asia) Ltd., a "fund of funds" that diversifies its investment in funds worldwide, and the author of this paper, Makoto Ohsawa, director of JABR, co-chaired a panel discussion by experts who are active participants in the Japanese buyout market.2 What follows is a summary of this discussion.

  • 2 Four buyout companies, MKS Partners, CVC Asia Pacific, Olympus Capital, and Newbridge Capital Japan, were represented in the panel discussion.

Maturing Buyout Funds and their Economic Effect

The number of the world's buyout funds, a type of private equity fund, has increased fivefold since the early 1990s. During this period, they have evolved into a type of operation that aims to maximize medium- to long-term corporate value through streamlining of overall operations or expansion of the lines of operation of acquired companies. Their style of value creation no longer depends solely on financial restructuring mainly through debt reduction, or on cyclical movements in stock prices (buying when stock prices are low and selling when prices are high).

In the past two decades, buyout funds have outperformed the S&P 500 by more than four percent, and, according to a survey on European buyouts, they have generated substantial benefit for the employment and capital expenditure of the companies invested in. A separate survey shows that, in the United States, the performance of companies invested by buyout funds (financial buyers) was far superior to that of companies invested in by corporate sponsors (strategic buyers). It is thus common knowledge in the U.S. and European markets that buyout funds bring substantial benefits to both investors and the companies in which they invest.

The Japanese buyout market has been expanding since the latter half of the 1990s under the pressure of restructuring of the financial sector and the general retreat from noncore business lines against the background of global competition. Since 1999, there have been about 30 deals worth more than 1 billion yen.

Cases of Effective Use of Buyout Funds and the Keys to Success

Buyout funds can help yield positive results in various cases. The following are a few examples. First, the buyout of a family concern, the objective of which is to establish a new management structure, where family members' capital ownership and involvement in management are eliminated. Emphasis is placed on retaining employees and providing work motivation, through, for example, their holding of the firm's stock options. Second, when a firm sells one of its strategic sections to raise funds to write off bad loans, a buyout fund created jointly with the vendor can convert the section into a separate firm. The vendor's balance sheet will improve, it will retain effective control over the new firm, and the new firm's business will be reflected in the consolidated business results. And third, in the case of a firm that has a potential for higher profitability but lacks strong management, the buyout fund can reinforce both its capital and management.

In Japan, the great influence financial institutions wield over failed firms or firms on the verge of bankruptcy has tended to exclude participation of buyout funds in the market. Recently, however, there have been cases where buyout funds have been able to assist the recovery of firms undergoing bankruptcy proceedings. A typical example is Benkan Corporation, previously the world's largest manufacturer of plumbing equipment.

The keys to a buyout fund's success are: (1) development of a strategy well-tuned to the corporate culture of the country where the firm invested in is based; (2) development of a medium- to long-term management strategy; (3) provision of incentives to bring out employees' potential based on mutual trust between management and employees; and (4) making full use of the effective managerial experience accumulated through other cases of corporate recovery.

Obstacles in the Way of Buyout Funds Playing a Greater Role in Japan's Business Recovery

Many buyout funds have entered the Japanese market in recent years and thus there is no shortage in the supply of funds. Furthermore, the legal provisions concerning corporate bankruptcies have been revised and made up-to-date with speed.3 Nevertheless, the following factors continue to hinder the activity of buyout funds.

  • 3 See Matsushita, Junichi, "New Corporate Reorganization Law ," INSOL WORLD, Winter 2003 for details of the amendment of the Corporate Reorganization Law in Japan.

First, there is a deep-rooted prejudice against buyout funds among firms, banks, and investors, who invariably regard them as "vulture" funds - funds that buy claims on firms in distress at bargain prices with the sole aim of making a quick profit through highly aggressive restructuring measures and debt collection methods.

Second, financial institutions are generally reluctant to implement financial restructuring through such means as debt forgiveness and debt equity swaps, and to extend limited or nonrecourse loans as a means of business reconstruction to improve profitability. Another hindrance arises from the current rule of banking supervision that classifies loans to a subsidiary of a failed parent company as bad loans.

Third, corporate managers in most cases are not sufficiently determined to maximize corporate value, while at the same time it is difficult to find an external team of managers to replace them with good experience in corporate restructuring.

Fourth, there is a general lack of credible historical management data to ensure due diligence.

And fifth, exit routes for buyout funds are not adequately in place because the liquidity available to newly emerging companies is generally limited in the stock market.