It has been a strong year for Japan-focused private equity dealmaking and fundraising, but consultancy Bain & Company has warned of fierce competition for big deals and a likely squeeze on investment returns.

The value of PE deals done had already reached nearly $24 billion in the first nine months of 2017, according to the consultancy’s seventh Japan Private Equity Report, released today (October 16). This figure—driven by the sale of Toshiba’s memory chip business for $18 billion to a consortium led by private equity firm Bain Capital—is already an annual record, with three months of the year still to come. 

Moreover, $16 billion had been raised for investing in Japan PE as of October 13, the most gathered in a year since 2007 ($25.6 billion), according to data provider Preqin (see figure below).

Japan-focused private equity fundraising, 2000-2017 (Source: Preqin)
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It has also been a strong year for exits, noted Bain & Co, with $8 billion recorded so far and $10.7 billion forecast by the end of December, up from $4.8 billion in 2016 and $7.6 billion the year before.

Future challenges

However, all these investors face challenges—in short, it will be harder to make money in light of the increased competition for a limited number of deals.

Jim Verbeeten, head of Bain & Co’s Japan private equity practice, said: “High entry valuations due to abundant debt and equity capital will require planning for multiple compression."

The entry multiple on a deal is viewed as a helpful predictor of likely returns for private equity investments. That is logical, since higher initial discount rates tend to produce higher returns across assets.

Verbeeten also pointed to the fact that big deals were scarce in Japan because of the highly fragmented universe of corporate sellers there. “Competition for deals over ¥25 billion [$223 million] is intense, with PE often battling corporates,” he said.

Moreover, most deals being done now will remain in an investment portfolio until 2020-2022, meaning they are likely to face a downturn during the holding period, noted the report. As a result, noted Verbeeten, “capturing value and de-risking investments early on is becoming ever more important”.

PE market growth drivers

The rise in divestitures and overall deal value in Japanese PE has been driven by improving corporate governance, said the Bain report.

For instance, shareholders are steadily putting more pressure on underperforming boards and the vast majority of companies now have two or more independent directors, a big turnaround from the situation just three years ago (see figure below).

Corporate governance momentum building in Japan
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In turn, foreign investors—also known as limited partners—are showing more interest in Japan PE, noted Bain & Co, and domestic LPs have been increasing allocations to the asset class. For instance, the country’s huge Government Pension Investment Fund is now making moves into private equity. The fund has around $1 billion in the asset class now, but has a stated target of $65 billion, said the report.

Yang Zhan, Hong Kong-based principal at PE secondaries firm Coller Capital, agreed that interest in Japan PE had re-ignited, speaking to AsianInvestor in June.

He pointed to several drivers, including an ongoing generational transition in corporate Japan and Abenomics—Japanese prime minister Shinzo Abe’s stimulus programme.

Moreover, Japanese people are more accepting of PE investment than in the past, said Yang. Corporates are seeing more and more cases where private equity is helping their business, he noted.

In addition, PE managers have increasingly recognised the need to offer long-standing management teams incentives to align them closely with the performance of the business, he noted.

Story updated to clarify difference between Bank & Company and Bank Capital.