Divestment activity by Japanese conglomerates is finally translating into meaningful private equity deal flow, but unwinding people and assets from longstanding parents presents execution challenges.
Sheer size no longer appears to matter at Hitachi. The company generated revenue of JPY9.16 trillion ($83 billion) for the 12 months ended March, down slightly on the 2008 figure, reflecting how a once sprawling business empire has been pared back and refocused. Profitability, meanwhile, has gone through the roof. Even in 2006, before the global financial crisis hit, Hitachi posted a net loss. This ballooned to JPY787.3 billion in 2008. Last year, net income reached JPY338 billion.
Making his first address to shareholders as president and CEO in Hitachi’s 2009 annual report, Takashi Kawamura promised bold structural reforms. By all accounts, the company has delivered. Non-core businesses ranging from precision small motors to printed circuit boards were sold off or discontinued. In part through M&A, Hitachi doubled down on high-end IT, power systems, and social infrastructure, becoming more global in the process.
Hitachi sticks to the “social innovation business” mantra that Kawamura outlined in 2009. But it has been modified to suit the digital age, emphasizing artificial intelligence and big data analytics. Acquisitions continue, and so do divestments. In the last six months alone, the company has fully exited Hitachi Koki to KKR and partially exited Hitachi Kokusai Electric to KKR and Japan Industrial Partners.
“The company has been very aggressive in divesting certain business lines – it created an organizational climate that is friendly to restructuring,” says Tatsuo Ushijima, a professor in the faculty of business and commerce at Keio University, who specializes in corporate restructuring. “It is a successful case of a corporate turnaround using divestments.”
Toshiba has emerged as a poster child for corporate carve-outs in Japan, with a host of PE and strategic buyers jockeying for position in consortiums that are expected to bid in excess of $10 billion for its flash memory business. But this is a fire sale ignited by the bankruptcy of Westinghouse. Elsewhere, divestment activity appears more considered – arguably not as aggressive or progressive as Hitachi, yet certainly different from what came before.
“The deals we saw in 2004-2005 were ‘negative carve-outs,’” says Ryuzo Maeno, a senior managing director at Endeavour United, which was established by the team behind Phoenix Capital. “Corporate Japan was not performing well; companies had too much headcount and too many liabilities. Now the financial results are not bad. Companies are considering their options, selecting core businesses and carving out non-core ones. We will see a boom in this kind of transaction over the next couple of years.”
Just this week, Endeavour United completed the acquisition of Pizza Hut Japan from Mitsubishi Corporation-controlled KFC Holdings Japan. It is the latest in a string of such deals that helped propel private equity investment in Japan to $11.1 billion last year, the highest level seen since before the global financial crisis. The total for 2017 to date stands at $5.6 billion.
KKR has announced three billion-dollar-plus carve-outs within the last seven months and completed two of them, including a $4.5 billion tender offer for Calsonic Kansei Corp, having first won an auction for Nissan’s controlling stake. However, mid-market private equity firms are also seeing more activity. Unison Capital, for example, has made four carve-out investments in the last 24 months, in industries ranging from pharmaceuticals to building materials.
Big or small, the motivations are similar. Policy has played more of a role in recent years: the stewardship code was enacted, outlining the responsibilities of institutional investors; the JPX-Nikkei Index 400 was introduced, which assesses candidates based on criteria such as return on equity (ROE), the use of independent directors, and transparent reporting; and the corporate governance code has come into force, with a view to better aligning the interests of corporate parents and public shareholders.
While these mechanisms are expected to contribute to deal flow, progress is gradual. Introducing independent directors might lead to more objective decision making – which could include divesting non-core assets – but removing the “company men” hegemony from Japanese boardrooms is difficult. “We need momentum to achieve critical mass, which may take 4-5 years, but steps are being taken in the right direction,” says Ken Kiyohara, a partner at CMA Partners.
Rather, the emphasis on ROE is a contributing factor as corporate Japan tries to answer a more fundamental question: how do you maintain competitiveness in an increasingly crowded market? For many, the mandate is to focus on a handful of key industry verticals, which means non-core divisions are sold off to provide capital for more strategically relevant overseas acquisitions or internal redeployment.
“For quite a long period after the bubble burst in the early 1990s, Japanese banks could still hold the line on funding unprofitable businesses. The structural competitive fundamentals these companies are facing has overwhelmed that now. The psychology has changed and non-core divestments are now socially acceptable,” says Mark Chiba, group chairman and partner at The Longreach Group. “The genie is out of the bottle.”
He points to Longreach’s acquisition last year of Nippon Outsourcing Corporation from Olympus as a classic non-core divestment. The company was Olympus’ in-house administrator and over time took on external clients as a means of contributing to the parent’s bottom line. Nippon developed into a fully fledged and profitable business process outsourcing (BPO) operation, but ultimately it has little in common with Olympus’ other divisions.
Sourcing the deal was a matter of years, not months. Like its peers, Longreach tracks a long list of corporates and identifies potential carve-out candidates. The BPO transaction marked the end of one strand of an ongoing, multi-year strategic dialogue with Olympus about where it wants to take its overall business.
In this sense, private equity firms have to be patient in their approach, allowing the role of dealmaker to be subsumed by that of corporate counsel. GPs must believe that, once they establish themselves as trusted partners, investment opportunities will follow. Even if the seller feels obliged to run an auction process for an asset, the number of participants might be limited and a bidder that has already shared ideas regarding divestments could hold a distinct advantage.
Kazuhiro Yamada, managing director and head of Japan at The Carlyle Group, notes that when the firm bought Senqcia Corporation from Hitachi Metals in 2015, an auction was avoided because the dialogue over this specific divestment had started five years earlier. “Normally, when the parent is a public company you have an auction. We got exclusivity because we were able to present a convincing value creation plan to the parent,” he says, adding that most of Carlyle’s deals are proprietary.
Generally speaking, these value creation plans must explain how a division can thrive as a standalone entity under new ownership. Commenting on its decision to divest Pizza Hut Japan, KFC Holdings said there was a need to strengthen the business in the face of intensifying competition. As such, Endeavour intends to reduce costs, but it also sees an opportunity to invest in an entity that has been starved of capital. The GP wants to expand the network of 370 outlets and diversify the business model, taking the fight to the market leaders.
Arguably the highest profile example of post-investment transformation in recent years is Panasonic Healthcare. When KKR bought a majority stake in the asset at a valuation of JPY165 billion in 2013, it was said to be the first time Panasonic had sold a profitable business to a PE investor. The company took this course of action in the expectation that an external partner with capital and a global healthcare network could support future growth in the business.
The following year Panasonic Healthcare completed the bolt-on acquisition of Bayer’s diabetes care division, consolidating the company’s global footprint. When Mitsui & Co. bought a 22% interest in Panasonic Healthcare last year at a valuation of JPY245.9 billion, it not only enabled KKR to make a partial exit but also offered an indication as to how the business has grown in value. This success has helped KKR open up new carve-out opportunities.
“Our partnership with Panasonic Healthcare has been a great example of the capabilities that private equity partners can bring to Japanese corporations, and how KKR can leverage its global platform to assist Japanese companies’ growth,” says Ming Lu, head of Asia private equity at KKR. “This has been a great topic of conversation with other corporations we’ve met in Japan and across the region.”
The global angle is also said to have helped KKR underwrite the transaction to a higher valuation, enabling it to comfortably outbid the opposition. As one industry participant puts it: “The big guys can really pay up. One, their capital hurdles are lower – they are deploying so much in an absolute sense that a 2x return is great. Two, if they see a potential global platform build, they can pay up because their context is different.”
Overpaying and overleveraging are two of three broad areas in which carve-outs can go wrong; the third is undermanaging a business post-acquisition. Misjudgments are felt particularly acutely in deals that involve industrial technology assets, which tend to be capital intensive and subject to cyclical demand. Covalent is frequently cited as an example of a carve-out that didn’t turn out as planned; as well as being an industrial business, it is one of the class of 2006 mega-deals that failed to live up to their hype.
Carlyle and Unison paid JPY91 billion (then $774 million) – supported by JPY65 billion in debt – for the company, then known as Toshiba Ceramics. The underperforming silicon wafers business was offloaded to a Taiwanese trade buyer for JPY35 billion in 2012 and the remaining ceramics operation came close to a default before eventually being sold to a US group in 2015 for an estimated JPY50 billion.
In addition to problems with the amount of leverage, a source familiar with the investment identifies two problem areas. First, the semiconductor industry underwent a significant shift, with manufacturers in Korea, China and Taiwan scaling up their operations, and this hit projections for business growth. Second, Covalent was heavily reliant on sales to Toshiba and its employees retained an affinity for their former parent, making it harder to bring about change in governance and corporate culture.
Industry headwinds might be difficult to predict, although GPs are able to minimize downside risk by ensuring portfolio companies have strong capital structures. The direct commercial impact of unraveling a subsidiary from its parent can also be offset by agreeing long-term contracts with the seller that give some certainty of cash flow while third-party business is expanded. In certain situations, the parent retains a minority stake in the subsidiary post-divestment, so a degree of alignment remains.
The human element is harder to gauge. Private equity investors must be confidence that management teams have the mindset to adjust to life away from the mother ship – and if not, that senior executives can be brought in without destabilizing the business. A common approach is to hold discussions with management, have them understand why additional talent is required, and when a new CEO comes in, move the incumbent to a chairman role.
Maeno of Endeavour United notes that the Western habit of using stock options to win over individuals isn’t necessarily as effective in Japan. Carve-outs account for about 10 of the 40 deals completed by Phoenix and Endeavour, but large monetary incentives for management haven’t featured. “They are looking at professional success more than monetary success,” he says. “We have to give them a clear vision for the business so they are comfortable working with us.”
These considerations are one of the reasons why Carlyle deal sourcing efforts start with the management. “Generally, our first contact is with the management team of the target,” Yamada explains. “We want to get to know the company, its business culture, and its strengths and weaknesses. Then we present to the seller. This is the most effective way because sometimes when we approach the seller they are hesitant about us speaking directly to management.”
The earlier management buys into a PE firm’s growth plans for a business, the smoother the transition. Last year, Longreach acquired the Wendy’s franchise for Japan and paired it with First Kitchen, an existing restaurant chain carved out from Suntory Holdings. Having recruited a new CEO and CFO from Freshness Burger and McDonald’s, respectively, the GP was mindful that the existing staff might be unhappy about their separation from Suntory. It needn’t have worried.
“They were happy to have someone behind them with a growth plan, rather than being an orphan division of a conglomerate. As a result, we decided to accelerate the conversion plan,” Chiba says. “You never really know about these things until a deal closes. You do all the due diligence and negotiate with the key players; but there’s nothing quite like that moment when you present to all the employees, outline your plans, and then see their initial reaction.”
No turning back
There is little doubt among industry participants that the stream of corporate carve-outs in Japan will continue. The competitive pressures driving companies to divest non-core assets are unlikely to abate, while shareholders will develop a stronger voice as corporate governance reforms take hold. At the same time, as long as interest rates remain low, local banks will be keen to provide debt funding for these deals.
Private equity can also expect to benefit from a greater understanding of what it does. More Japanese executives have experience working and studying overseas, so they see the merits rather than the stigma of divesting assets, and they recognize that financial sponsors can be useful partners in these situations. Furthermore, GPs can point to past investments in which carve-outs have resulted in increased employment, empowered management, and renewed growth.
Indeed, more corporates are hiring consultants to conduct strategic reviews and initiating auctions of non-core assets, which suggests a greater willingness to engage with PE buyers and an increase in deal size (a business needs to be worth at least $500 million to justify a full auction). “We are getting a lot more auctions PE firms are also becoming more ambitious,” says Tsuyoshi Imai, a partner at Ropes & Gray. “That’s part a result of Japanese banks’ willingness to lend more and part a result of the changing landscape in Japanese private equity.”
Imai observes there are a lot more GPs targeting deals of $1 billion and above than has been the case historically, yet he works on 4-5 smaller proprietary deals for every big auction. For example, AVCJ Research has records of four private equity carve-outs from Panasonic in the past four years. While Panasonic Healthcare was a heavily contested auction, the other three were sold through bilateral or limited processes.
The question for private equity, therefore, is how quickly the deals will come and how big they will be. The answer lies in assessing the extent to which the recent increase in activity represents a broader shift in corporate Japan.
Carve-outs are an established facet of other developed markets and the prevailing trend among industrial technology giants over the last 10 years has been to transition from hard assets to software platforms. Hitachi’s social innovation imperative is already clearly reflected in the divestment and investment activity of the likes of IBM, General Electric and Siemens as they have jettisoned PCs in favor of the internet of things. Japan might be on the same path, but for the majority of companies, progress is more gradual.
“There will continue to be large carve-outs and the pace at which they happen will accelerate, but what feels like a large wave of deals is still small relative to the overall industrial base,” says Paul Ford, a partner at KPMG FAS. “With the size and range of businesses these conglomerates are involved in, and the extent of inter-company trading relationships, we are still just scratching the surface of the long-term opportunity for PE-backed industrial expansion."
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