Japan emerges from the shadows | A new generation embraces M&A | Nikkei heads for 24,000 by 2010… or sooner | Debt is not a dirty word | Living in the past; paying with the future
JAPAN IS NOTHING if not conformist. Centuries of tradition and strict social etiquette impose restraints on the individual for the benefit of society. An air of calm pervades the well-ordered streets of Tokyo where even policemen, parking attendants and security guards salute and bow smartly to passers-by. So when someone does something unusual in Japan, it usually gets noticed.
It is unlikely that few locals took much notice of Shuhei Abe when he founded Sparx Asset Management in 1989 as president and CEO. That cannot be said today: Sparx, which is listed on Japanese growth market Jasdaq, manages $14 billion of investments and boasts a market capitalization of some $3.5 billion. Abe identified early on of the inevitable changes faced by corporate Japan in the wake of its economic crisis and this accounts for his company’s spectacular growth.
“The Japanese economy was forced to change and the procedures used in the past to enhance productivity also had to be changed,” says Abe, who is the president and CEO of Sparx. “Before, it was dominated by a system of cross-shareholdings driven by the ministry of finance. Banks controlled the corporate system, both equity and debt. They owned more than 50% of the entire market.”
When the crisis hit and banks could no longer afford to hold shares, they started to sell. “Then the issue arises,” says Abe, “of who will own the system of Japan Inc? It changed from the banking system – call it the government – to the market. Banks now own less than 25% of the market. They really have no voice.”
Instead, market disciplines are taking over. While the transfer continues, management of many companies has been slow to embrace the new demands of the market and that, says Abe, is where the opportunity lies. “We started our strategy to capitalize on this change of ownership. While the shift has been dramatic, the business practices have not changed. That’s the opportunity for us.”
Sparx buys shares of companies that it believes to be undervalued. It will acquire a stake that allows it to influence the board and then assist management to realize its assessment of the company’s true value. There are a number of ways to achieve this, says Abe, some of which are as simple as fixing basic finance issues. “An early stage of this game is a balance sheet problem,” he says, “the optimal use of capital. That wasn’t a problem before: capital was available almost infinitely. There was no understanding of cost of capital. If you’re not beating your cost of capital, then someone’s subsidizing it. That used to be the banks – not any more: markets aren’t that friendly.”
Failing to succeed
Markets are certainly becoming less friendly in Japan. Although Sparx prefers to conduct business in an amicable way, others are more heavy-handed. One of Japan’s best-known activist funds is M&C Consulting, often referred to as the Murakami Fund, founded and run by former government bureaucrat Yoshiaki Murakami. In 2000, M&C hit the headlines by launching a hostile bid for real estate group Shoei. In 2002, the firm built a stake in women’s clothing business Tokyo Style, and tried to force the company to increase its dividend payout.
The attempts failed but the share prices of both companies jumped as a result of Murakami’s attentions and his fund made a handsome profit. In fact, says Mark Mason, director of the programme on alternative investments at Columbia Business School, New York, and a Japan funds specialist, in the case of some of Japan’s activist funds, failure is a key ingredient of their success. “There are some greenmailers in this [activist] group,” he says, by which he means raiders seeking a payoff of some sort to desist from a takeover bid. “The last thing they’d ever want to do is to get control of one of these companies: they wouldn’t know what to do with it. But that’s not to say it’s bad.”
Steel Partners arguably falls into this group. Backed by US fund Liberty Square Asset Management, Steel caused uproar in corporate Japan in 2004 when it launched tender offers for two obscure listed companies, Yushiro Chemical Industries, an industrial lubricants business; and Sotoh, a maker of textile dyes. After the companies had been neglected for years by the market, analysts at Steel noticed that both of them were sitting on cash piles in excess of their market capitalizations. Both tender offers failed but the result could hardly have been better for Steel. In order to fend off the unwelcome approach, management at both companies increased dividend payouts to all shareholders more than tenfold. Sotoh also launched a buyback programme to boost returns.
That’s capitalism
With that kind of a result, it is difficult to complain about the activist funds’ strategies, especially as they tend to benefit all shareholders, argues Mason. “There have been some high-profile groups,” he says, “but these guys are looking at so many companies that haven’t been managed along western lines. Either they will restructure themselves or someone’s going to do it for them. That’s capitalism.”
It is a robust view, but one shared by Abe at Sparx, although he questions the long-term sustainability of such a model. “I’m not part of the crowd that goes to get the cash from a company and then sells,” he says. “Companies should be a constant value creator. If you’re just holding the shares for a month, forcing them to pay out and then selling, I’m not sure that’s a sustainable argument. But I don’t criticize their right to exercise their shareholder rights: a company cannot choose which is a good or a bad shareholder. That’s capitalism.”
Abe insists that Sparx’s approaches to companies are all friendly and explains why it can afford to behave this way. “We use a very simple valuation measure,” he says. “The ability of the company to improve its return on equity. Returns on equity (ROEs) in Japan were 2% to 3%, now they’re 9%. In the US, they’re more than 20% and there’s no reason Japan’s should be lower. In a very severe deflationary environment, Japanese companies have improved their returns. If the recovery continues, which I think it will, then ROEs will naturally improve to 15% and if companies improve their use of assets, they’ll get to 20%. With this kind of tailwind, a friendly approach works better.”
Certainly Sparx appears to be achieving similar results to Japan’s more aggressive fund managers, without the attendant brouhaha. When the firm invested in Shimano, a maker of high-end bicycle parts, Sparx explained to the founding family members the theories of efficient use of cash and suggested a share buy-back programme, which resulted in the number of outstanding shares falling substantially, with proportionate improvements in returns to shareholders.
Actively engaged
That is a structural tool that others are also employing to good effect, although David Baran, founder and principal of Symphony Financial Partners, eschews the term activist. “We’d never call ourselves shareholder activists,” he says. “We’re engaged investors. We know what we’re buying, know what the opportunity is to see an increase in the share price and we work with management to achieve those goals.”
Baran’s point is that what he and his team are good at is value realization: leaving value creation to management. Their approaches, like those of Sparx, are therefore always friendly.
“We can only measure what’s going on by the share price,” he says. “Public markets aren’t valuing companies properly. It’s all to do with the schizophrenia of being a listed company in Japan. Management of most listed companies don’t ‘get’ that they have to go out and sell themselves all the time.”
Baran’s explanation for this corporate disorder is strikingly similar to Abe’s. “When a company needed money, it went to the bank,” says Baran. “It didn’t issue stock. If you’re not at the mercy of the market for finance, the need to be transparent and engaging diminishes. Pull the banks out of the equation and you’ve got a new constituency. We’re part of that. We talk about ROE, return on capital, ebitda margins, cash and asset utilization.”
Symphony also talks about the size of its share stake. “It’s a function of what we think will allow us influence with management,” he says. Baran equates influence with access. “We like access and constructive dialogue,” he says. “We’ve not been aggressive: it’s not necessary and not productive to take hostile positions. Life’s too short.”
Although the motivation to make an investment is similar to those of Murakami and Steel Partners, Symphony’s approach is more akin to Sparx’s. “There’s a huge mismatch between cashflows generated by Japanese companies and the returns being paid out to shareholders,” says Baran. “We look at things like a private deal: what would a private equity player pay for it, as if every other investor disappears? What’s my downside to owning this? Well bought is half-sold.”
Baran’s reasoning is that an investor such as Symphony must work with management and find its own exit since it cannot depend on local markets. “You have to have a governance environment in place that recognizes the partnership between management and shareholders. If you don’t have that, you’re basically trading stock on the basis that someone else will buy it from you. I don’t believe in that. I’ve never had faith in the Japanese or other Asian markets to find a real clearing price. You have to do it yourself.”
Symphony’s approach means that the portfolio is quite concentrated, as Baran admits, although the fund, barely two years old, has already exited some investments. Symphony appears to have bought well in the past: it already manages $750 million and is launching an Asia fund along similar lines to its Japan fund, which Baran says has produced an annualized internal rate of return of 25%.
That diversification might be in response to competition in Japan, which Baran concedes is increasing. “The size of money chasing returns has exploded exponentially in the last few years,” he says. “Japan’s still cheap but the cat’s out of the bag.”
Railroading the railroads
It is not just asset management firms that have been getting in on the act. Last year there were two high-profile transactions from listed companies aggressively buying large stakes in undervalued companies in an effort to exert influence over incumbent management. First was the attempted takeover of Fuji Television by Livedoor, the now infamous local internet company. Then came a bid from another internet business, Rakuten, headed by Hiroshi Mikitani, for another media business, Tokyo Broadcasting Systems. Both takeover attempts ended in traditional Japanese consensus-driven compromises but the events caused considerable angst among Japan’s business establishment.
Another listed company, Privée Zurich Turnaround Group, has been no less aggressive in its investment approach. In July 2005, the group announced that it had built up a 6% stake in Keisei Electric, a Japanese railway operator with valuable land assets. It has since increased this to 8.7%, although it claims to control more through other holdings. In January, Privée Zurich announced that it had also acquired a 5% holding in Hankyu Holdings, an Osaka-based railway and hotels business.
The group, which despite its name has nothing to do with Switzerland or banking, is headed by the former head of trading at Salomon Smith Barney, Kenzo Matsumura. It holds several subsidiaries, including Nissan dealerships and a logistics business. However, the firm appears to share its CEO’s predilection for trading assets. “Our first step is to put pressure on current management at Keisei to realize value,” says Matsumura. “We haven’t even met them yet. They’re very scared: management is approaching us though banks. They want to buy back our shares at a premium.”
Matsumura appears confident that his tactics will succeed. “The shares of railway companies are rising these days because of the rising real estate values,” he says, “and cashflow has improved due to more traffic. We’re expecting a revaluation of the assets of both Keisei and Hankyu.”
He has reason to feel confident, since there is a precedent for his tactics. In October last year, Yoshiaki Murakami’s fund built a 40% stake in Hanshin Electric Railway and tried to get management to sell its interest in the local Hanshin Tigers baseball franchise. The attempt failed but the value of the shares increased and, with it, Murakami’s interest, which of course was probably the original intention.
Matsumura scorns the typical fund management approach to investing. “Normal fund managers will screen and make bets then go to sleep and wait,” he says. “If we buy, say, 5% of the shares of a company, we have to disclose it. In the case of Keisei, when we announced it the stock surged, we still hold it and we’re increasing our stake.”
It does not seem all that clever but time will tell. Aside from investing in railway stocks, Privée Zurich’s corporate strategy is less clear. Quiz Matsumura on this and he talks about building a mezzanine finance business through a collection of stakes in unrelated securities businesses that he holds in a privately held company rather than in the listed vehicle.
What is clear is that Matsumura intends to gear up his listed vehicle heavily to pursue his strategy. Through leveraging the company and margin financing on existing shareholdings, he claims to command more than ¥300 billion ($2.6 billion) of capital. It seems a precarious plan but Matsumura’s ambitions appear to be matched only by the size of his office, which occupies the entire 36th floor of the swanky Kasumigaseki Building in central Tokyo.
Culture shift
While Japan’s economic recovery continues and its equity market recovers, Columbia Business School’s Mason expects to see more activist funds entering the market. “We’re going to see a lot more of these funds coming,” he says. “I don’t think they’ve missed the boat. The low-hanging fruit will be picked quickly and companies will put up stronger defences – the government is already helping them do that. But there’s so much going on in Japan, that the changes are inevitable.”
Despite appearances, much of those changes and the funds bringing them are supported indirectly by established business interests in Japan, claims Mason. “Murakami raised $1 billion from his first fund,” he says. “That’s the roughest, toughest domestic group there is and 52% was Japanese money. There are discussions right now about new funds in Japan. Some will be friendly, some less so.”
Rumours suggest that both Livedoor’s Takafumi Horie and Rakuten’s Mikitani are considering such moves, although the recent controversy surrounding Horie, whose company is under investigation for alleged accounting and market misdemeanours, makes that less likely.
Symphony’s Baran agrees that more funds are on the way and that much of the pressure for change is domestic. “With Japan ageing and payout ratios rising, these guys have hurdle rates,” he says. “The liabilities are there and they have to pay. That’s what’s squeezing the system. It’s domestic, not foreigners. Companies are learning, the government’s not. They’ve woefully mismanaged the nation’s assets and they haven’t understood the way out of their problem is a cultural shift.”
As corporate Japan continues to struggle with that cultural shift, the activist funds sector will continue to thrive. Sparx’s Abe welcomes their involvement but warns that Japan’s culture will never change completely. “There’s no right or wrong,” he says. “In the end, it’s your philosophy: how can you make a long-term return for your shareholders? But investors from a different culture naively assume that Japan is behind and they can simply use a barbarian way of doing things. Our system is not like that. It may work two or three times but how can you make it sustainable? There is a Japanese way of doing things: you can’t change that.”
