M&A in Japan

From the earliest days of the first Lost Decade (the Nineties) in Japan, sharply lower prices have generated merger and acquisition interest in flat-on-their-backs mid-sized Japanese firms that were both appallingly badly managed and stunningly cheap.

M&A activity in Japan has come in two forms, approaches initiated by domestic investors and those begun by foreigners, mostly value investors from the US.  Both have foundered badly, for somewhat different reasons.

Recently, interest has begun to surface from Chinese companies (see yesterday’s Financial Times) as well.  But their motivations are somewhat different from prior waves of suitors.  My guess is that they will be much more successful than their predecessors–but this will be rather to the sorrow than the joy of investors in the Japanese target names.

the Lost Decade (now fast becoming a Lost Generation) begins

The Japanese stock market bubble began to collapse in late 1989.  Within a year or two, many listed companies were trading at very low price to cash flow multiples, 30%-50% discounts to book value, and in some cases discounts to net working capital or to net cash on the balance sheet.

M&A wave 1:  foreigners

Tokyo appealed to American private equity investors to rescue the worst of the country’s banks.  It did so out of necessity–because banks in Japan were traditionally merely an arm of foreign policy and thus no one in Japan has the requisite turn-around skills.  When the fortunes of these institutions did reverse and foreigners made billions doing so, they also created a political problem.  For one thing, they made the government look bad because it had set such a low entry price.  In addition, the traditional Japanese way of dealing with an embarrassment of riches was to give some of the money back.  The private equity Westerners refused.  So they–and anyone like them–were ostracized from that point on.

British and American portfolio investors also bought shares in Japanese companies that were trading at valuations unheard of for a generation in the West.  After establishing positions, they approached managements with suggestions about operating changes and/or requests that idle cash be dividended back to shareholders.  They were rebuffed.  When they mounted proxy battles, the target’s customers and suppliers bought shares and voted to keep the incumbent management in office.

The government wasn’t an idle spectator in these struggles.  On the one hand, Tokyo informally encouraged the banks to continue to support even the worst credits, thus delaying by many years the “creative destruction” that would ultimately improve the prospects of survivors–and by so doing kept capital in the hands of managements ill-equipped to put it to productive use.  In addition, however, the Diet over the years passed a series of bills that in practice made it impossible for a foreign firm to take control of a Japanese one.

wave 2:  domestic investors

True, friendly mergers within an industry are allowed.  But the fate of domestic investors aiming to reform Japanese business practices is typified by the case of Yoshiaki Murakami, a former trade ministry official who specialized in M&A regulations.  Mr. Murakami had noble ideals.  He wanted to use M&A  put domestic capital into more capable hands.

His first target was Shoei, a kimono maker whose business was in severe decline but which owned extremely valuable real estate in Tokyo.  Mr. Murakami’s plan–he had raised money for a buyout fund on the strength of his trade ministry credentials–was simple (read: naive).  Fuji Bank held a large position in Shoei and, he reasoned, was obliged legally from having taken government bailout money, to sell non-core assets.  Therefore, the bank would be receptive to an approach to buy their shares at a premium.  Also, Canon, the electronics firm, held a significant interest.  Preliminary inquiries suggested it might be willing to sell.  So Mr. Murakami’s fund built up a holding an attempted to take control.

He failed miserably.  After the fact, he told me he had mis-assessed two factors:

–in a form of amakudari (descent from heaven), the heads of Shoei were all retired high-ranking Fuji Bank officers.  Shoei was in effect their pension plan and they had no intention of giving it up.

–the president of Canon vetoed a sale of the company’s stake.  He told Mr. Murakami that Shoei had lent the president’s father money so that he could found Canon.  The president felt he could never face his father again if he had a hand in Shoei’s demise.

What ultimately happened to Mr. Murakami’s crusade?  He was arrested for insider trading, imprisoned and barred from the securities industry.

wave 3:  China

Why do I think the Chinese will be successful in their investments in Japanese companies?  For one thing, unlike previous M&A practitioners, the Chinese don’t want to reform the business practices of firms they are buying stakes in.  For another, they could care less about the stagnant Japanese economy.  What they are dangling in front of their targets in exchange for a stake in the firm is access to the large, and rapidly growing, Chinese market for their wares.

I think it’s a mistake, however, to look at these deals from the perspective of the Japanese firm.  It seems to me Chinese companies are looking for:

–either intellectual property (like brand names) or manufacturing skill that can easily be used in their domestic operations.  I suspect that the Japanese partner will gain little benefit from this transfer.

–having watched the Japanese establishment act for decades to the disadvantage of foreigners in almost any way possible, I think the Chinese also want a big enough stake in the Japanese target that they can’t easily be shaken loose–through, say, a heavily dilutive merger with another Japanese company.

Chinese presence in Japan will be interesting to watch.  From an investment perspective, it seems to me the only way to make money from developments will be through owning the Japanese side.