Japan’s Improving Investment Environment

Monumental changes have been taking place in Japan since the asset bubble burst in 1990. Some have described this period of asset deflation, free-falling real estate prices, near zero interest rates, crashing stock prices and stunted economic growth as the “lost decade”. There is no doubt that it has been a bleak period full of disappointments as investors and businesses anticipated on more than one occasion an economic turnaround and a resulting market recovery. In our view, it has also been a time of monumental changes that are finally leading to a positive environment for the alternative industry and for the investment environment as a whole.

For many years Japanese corporate life was dominated by long term corporate cross shareholdings where both financial institutions and listed companies held each other’s shares. However, beginning in 2000, banks have actively shed long-standing investments in listed companies. It is estimated the percentage of long term listed company holdings, held by banks, fell from over 20% in 1987, then to 10% in 2001 and more recently to 7.7% in value terms in March 2003. Leading up to the September 2004 deadline, mandated by the Japanese Financial Services Agency, banks have also been under pressure to reduce the amount of outstanding equity shareholdings to levels below their Tier 1 capital. Japanese banks have been required to report their full-year earnings under mark-to-market accounting rules since 2002 resulting in a steady sell down of shares. Whilst many specific banks have met their targets, in aggregate, their holdings are still relatively high and are likely to be reduced further. The pressure to reduce cross shareholdings also continued as the number of banks and financial institutions shrank due to a sharp increase in merger activity. Overall, cross shareholdings in the market have fallen from approximately 50% to just over 20%. At the same time, holdings by investors have risen from 50% to nearly 80%. This has led to a more favorable supply-demand balance in the equity market.

Corporations, driven by a need to raise funds for restructuring purposes also felt the pressure to actively sell their cross shareholdings. The business model is in the process of shifting from one of mutual cross shareholdings to ward off takeovers and reinforce relationships between members of one industrial group, to one of profit maximisation. This shift is partly attributable to an increase in the percentage of listed companies held by foreign investors who pressured them to focus more on profits and indeed corporate governance issues. This new environment is feeding the growth of hedge fund managers in Japan.

This last decade saw a rising number of corporate bankruptcies. According to Teikoku Databank Ltd estimates bankruptcies increased from 6,000 in 1990 to a peak of 19,458 in 2002 before falling 17% in 2003. Personal bankruptcies during the same period increased from an annual 2,200 in 1990 to over 22,000 in 2003.

This unprecedented level of corporate bankruptcies accelerated the disposal of non-performing loans and other distressed assets and has lead to a greater source of attractively valued investable assets. Distressed sellers were under such pressure that even choice assets were sold albeit unwillingly to foreign investors. In line with these disposals and a gradual recovery in the Japanese economy there has been a resultant increase in Mergers & Acquisitions (M&A), Management Buy Out’s (MBO’s) spins offs and restructurings. According to the Nikkei Weekly, there were over 1,700 corporate M&A’s involving Japanese companies in 2003, nearly matching the record set in the previous year. The focus has been on MBO’s and investments by turnaround funds.

Other emerging trends include a growing emphasis on shareholder value, some moves towards US style corporate governance amongst the larger listed companies and an increase in the pace of business decision-making as Japanese corporate culture adapts to a constantly changing environment.

The changing corporate environment has provided opportunities for foreign groups such as Ripplewood LLC, a private equity group that manages US$ 4 billion. Fifty percent of their capital is committed to Japan and invested in domestic firms. The recent landmark initial public offering of Shinsei Bank by Ripplewood’s consortium of private equity owners proved to be an attractive benchmark for calculating realizable gains. Other foreign groups such at the US based Steel Partners and their Japan Strategic Fund sent shockwaves through corporate Japan with their hostile takeover bids for Sotoh Corporation and Yushiro Chemical Industry Co., Ltd. Additionally a growing number of noted global value investors are actively increasing their stakes in Japanese companies, including such firms as the Cundill Group, Tweedy, Browne Co. and Longleaf Partners. Revisions to the Commercial Code have also encouraged potential investors to create new and innovative structures. Amendments to the code scheduled for 2005, will allow foreign corporations to acquire Japanese corporations through equity swaps (including the use of foreign shares) and are expected to promote even higher levels of M&A.

It’s interesting to note that whilst foreign groups have attracted headlines with their activities there has also been a steady increase in the number and size of transactions undertaken by domestic private equity groups. Corporate turnaround funds, run by domestic firms have attracted considerable interest from investors, including Japanese pension funds, raising more than Yen 1 trillion in assets. The government owned Industrial Revitalization Corporation of Japan (IRC) has a war chest of USD 100 billion and a five-year time frame in which to invest and exit deals. They recently announced their intent to invest in possibly as much as up to 50% of Kanebo and commit to a workout of the company’s troubled operations after a touted merger with Kao Corp fell through.

Much of the wealth in Japan has traditionally been tied up in real estate assets. Their value soared during the “bubble” period in the 1980s, only to come crashing down over the past decade. In an effort to revitalize this critical sector, the government allowed for the securitization of real estate assets in 1998. The Tokyo Stock Exchange listed the first of a series of Japanese real estate investment trusts (J-REITS) in September 2001. Given the estimated USD 4.9 trillion real estate market, some industry participants believe local REITS could be managing as much as USD 30 billion within the next three years. Land prices, while still falling in rural areas appear to be stabilizing in Tokyo according to data released in March 2004 by the Land Ministry.

Well-known and respected foreign forecasters believe that Japan’s immediate economic outlook remains upbeat. The Economist Intelligence Unit raised its forecast (June 2004) for real GDP growth in 2004 to 4.4% from 3% and estimates growth of 2.2%% in 2005.Even the Japanese Cabinet Office forecasts for GDP growth at 2% per cent in fiscal years 2004 and 2005. The quarterly tankan, a survey of business sentiment has been improving on a steady basis since 2002.

Against this backdrop, figures from the Tokyo Stock Exchange show foreign investors, including many global and pure Japan focused hedge funds, continuing to be net buyers of Japanese stocks. These net inflows culminated in a new record weekly net buying figure of Yen 967.8 billion set in early March 2004. Japanese individuals have recently established themselves as the second most active group of investors after the foreigners. Indeed in May of 2004, they eclipsed even the foreign investors, representing 75% of the net purchases of small to mid-cap stocks and 46% of the net purchases of even the big-cap names. While it may be somewhat premature to argue for a secular change in the investing patterns of the Japanese public, many market participants are beginning to feel that Japan has in fact turned the corner. Although Japan has outperformed other global markets over the last year, it remains inexpensive on a relative basis.

Teneo Partners is positive about the opportunities that exist in the Japanese market and is prepared to work with our clients, both Japanese and foreign to take advantage of the coming opportunities.