A "New" Type Of Venture Firm For A New Era Of Venture Investing in Japan

I was in Japan for the recent holidays and was fortunate enough to have a wide range of meetings with informative & interesting professionals across business & investing. One of the more unexpected & compelling conclusions I walked away with from these interactions involved the rapidly developing world of venture capital in Japan. More specifically, the opportunity to build a unique, value-add, later stage focused venture capital firm leveraging both a fund of funds & a direct investment approach.

Now, I know some may balk at the fund-of-funds concept given the “unnecessary” added layer of fees, however, I’ll argue below that there is a real need & value to such a hybrid vehicle, particularly in Japan & specifically one modeled after the successful U.S. firm, Greenspring Associates.

Before doing so, however, let’s walk through a brief overview of both the Japanese venture capital ecosystem today as well as that of Greenspring Associates. The “thesis” here may become clearer with a better understanding of each. I’ll note that some facts below may be incorrect around the edges, but I’d stress that one should focus on the broad stroke realities vs. the specific details for our purposes here.

The following are some high level facts about the venture capital asset class in Japan today. This is not meant to be an exhaustive analysis, but rather meant to provide a basic understanding of the most pertinent market realities.

· Excluding corporate venture funds, there is roughly 100 to 125 Japanese venture capital firms actively investing in domestic startups today. 96 to be exact if you assume the Japan Venture

Capital Association captures most every firm. As a point of reference, we are likely approaching close to 2,000 active VC firms in the U.S. market today; granted, the market is more developed & far larger of course. However, the bigger point here is that the pool of Japanese VC GPs has now reached a size where there is likely enough stratification today across quality, sector focus, etc. for a fund of funds to adequately diversify & to more clearly identify the top-performers

· On the topic of corporate VC, it is worth mentioning that such firms are a fast-growing, though still somewhat unsophisticated, early stage investing group in Japan. Funding their investments is a collective cash pile of ¥273 trillion yen (~$2.5 trillion) as of March 2019, an all-time record high. It should be noted as well that a fund of funds approach is generally very attractive for "novice" investors just beginning to learn about a new asset class, as is the case with many Japanese corporates. The same can also be said for foreign LPs exploring the Japanese VC asset class - they are likely rather unfamiliar with the specifics of the Japanese VC ecosystem and, at least initially, less inclined to expend resources to directly overcome this knowledge gap. As it relates to Japanese corporates, you are seeing a degree of this FoF approach today whereby they establish a so-called "two-person fund" in which a single company outsources its startup investment activities to an independent, generally established, venture investment group.

Nikon & SBI Investments joint fund is a good example of this.

· LTM investments into domestic startups as of the end of Q319 was ¥197 billion, or ~$1.8Bn (at today’s exchange rate of ¥109.5 / USD), with 1,414 investee companies & an average check size of ~$1.3M. Supporting data is presented below.

· Japanese startups are often seen as going public far too early from the perspective of Western investors & entrepreneurs. There are a couple of reasons for this:

· For starters, a public company specifically in Japan enjoys a greater level of respect & credibility across the board versus the average private business. This is especially helpful in recruiting (in a country where there are 1.57 active job openings per job applicant), customer & supplier relations & finance-ability from notoriously risk-averse Japanese banks

· Secondly, and most importantly for our purposes here, there is a dearth of later stage growth capital in Japan. While this is slowly changing, for all intents & purposes, it basically doesn’t exist today. As such, fast-growing, young startups seeking what would be an effective Series C & beyond are often left with few choices, if any at all, beyond an IPO to raise growth capital. This is backed up by data when considering that the average amount raised in an IPO on the JASDAQ (Japanese stock exchange focused on emerging venture companies) is roughly $7M - which is frankly not even considered “growth capital” in the U.S. To tie it back to the bullet point just above, we feel most in Japan would agree that a lively, value-add, later stage venture investing ecosystem would trump the aforementioned advantages of a startup going public.

JASDAQ stock exchange data. Source: Deloitte

· The Japanese Government is aggressively encouraging further development of the venture capital industry & the associated innovation that comes with ambitious startup companies & entrepreneurs. For example, the Japanese government plans to allow Japanese companies to deduct 25% of the amount they invest in startups from their annual taxable income.

· While the angle we are pushing here is targeted towards international LPs, one cannot ignore the enormous Japanese pension funds who have recently begun to increase their allocations to alternative investments. To highlight this opportunity, the Government Pension Investment Fund of Japan’s current portfolio (with a total size of $1.5 trillion, about the size of the economy of Australia) has investments in alternatives that remains relatively small, at 0.35% of the portfolio (~$5Bn). However, as mentioned above, the aim is to increase investments in this space with a maximum 5.0% target (incld. real assets, infrastructure and private equity, more broadly). At even half of this max target allocation, that is ~$30 billion of incremental capital to be allocated both domestically and internationally over the next 5 years or so. Similarly, Japan Post Bank, also a government backed entity, began a plan in mid-2018 to increase its exposure to alternatives by $78Bn (<5% of its total AUM). Worth noting as well is that in 2018, Japan Post Bank and its sister entity, Japan Post Insurance, formed the Japan Post Investment Corporation, allowing the companies to invest directly in real estate, private equity and other alternatives. According to

Pitchbook, “Japanese corporate pensions now have a record 21.3% target allocation to alternatives. Initial allocations suggest most of this exposure is likely to come via funds-of-funds, which have been the traditional access point for new private market investors and can often provide resources to help novice investors get up to speed.” All in all, there is likely to be a significant jump in just domestic capital flowing into the VC asset class over the next 10 years & beyond, benefiting entrepreneurs, VC GPs and, presumably, pumping up private startup valuations, particularly in the to-be-developed later stage investment universe.

As it relates to more anecdotal data points, it has become increasingly clear on the ground that the quality of both VC investors & entrepreneurs is rapidly improving in Japan. While still lagging those of more developed startup ecosystems, we can point to numerous examples of startups looking beyond the “me-too” business models of the West, entrepreneurs embracing a more global perspective from Day 1 & VCs bringing a more value-add approach to supporting their portfolio companies. Nonetheless, significant skill gaps, broadly defined, remain across numerous dimensions. However, this “gap” does arguably offer meaningful “to-be-realized incremental alpha” for LPs allocating to the best of breed Japanese VC GPs over the next 10 to 20 years.

Some relevant supporting graphics from Venture Enterprise Center of Japan below:

Since Q3 2018, we’ve seen an upward sloping trend of invested capital with ¥30.1 billion (~$275M) of incremental investment YoY. We’ll see how well this holds up moving into 2020

No discernible trends above really, though when compared to pre Q1 2016 (see below), we can see a clearer & more sustained level of fund launches & capital raising in recent years:

While admittedly just a quarterly snapshot, the below data around fundraising by investor type into Japanese VC funds in Q3 2019 is telling & broadly representative of the industry as a whole. Most important to highlight here for our purposes is the “Overseas Total” of ZERO.

We’d also like to point out a general view of ours that global venture capital investments, while having grown tremendously over the last 10 to 15 years, is set to only further blossom in the 2020s & beyond, particularly outside of the core, arguably "overcapitalized", markets of Silicon Valley & China (i.e. regionally in the U.S., SE Asia, Japan, etc.). As a private or institutional investor increasingly allocating to VC, it will become more & more important, in our opinion, to diversify investments into these more “fringe”, less developed VC markets, where existing, local dynamics & present VC ecosystem realities provide for unique, differentiated & still largely untapped upside.

It is also our understanding that there are currently no VC fund-of-funds currently in existence that are exclusively focused on the Japanese market (please reach out if you know of any!). The closest thing we have come across is Mistletoe, a venture firm founded by Taizo Son, the younger brother of Softbank’s Masayoshi Son. While we don’t know the firm’s LPs, presumably Taizo’s personal wealth represents a significant portion of committed capital alongside other domestic Japanese investors - so, likely very little, if any, foreign investors.

Alright, let’s quickly capture the key elements from the above:

· In our view, the venture capital asset class will continue to flourish, though particularly within “non-core” markets, which offer a faster growing opportunity set, albeit from a smaller, less sophisticated base

· The Japanese VC ecosystem is rapidly developing and is arguably in the midst of an inflection point today, with significant unrealized upside among both VC GPs & entrepreneurs, who will continue to close the “skill gap” relative to more developed, global startup & VC peers

· From a base of effectively zero today, there is an extraordinary need for later stage venture investment in Japan

· International investors are under-allocated to Japan in general & Japanese venture investments in particular. The outdated, blanket view of Japan as a moribound, slow-growth, culturally closed off market is increasingly misplaced. We believe the reality on the ground is fast- changing & will only further improve given on-going changes to immigration, taxation, corporate governance & other economic / business friendly policies

Alright, so now, a quick overview of Greenspring Associates.

Greenspring Associates was founded in 2000 with offices today just outside of Baltimore, MD & Palo Alto, CA. The firm’s AUM is presently around $9.7 billion across diversified, direct, secondary and bespoke venture strategies. Greenspring is primarily a fund-of-funds investing in the world’s top venture capital funds. Such fund investments include those of the following firms:

Notably, the firm’s focus is largely on the U.S. today, though they do have exposure to international VC funds and a few direct investments, primarily in China:

What is most interesting & compelling, though, in our view, is that Greenspring specifically flags a portion of its raised funds for direct investments. In closing their recent $999M Fund IX, for example, the firm commented:

“GGP IX is expected to deploy the majority of its committed capital to established and emerging global venture capital funds while reserving a meaningful percentage for direct investments in information technology, communications and healthcare companies. Additionally, the Fund will opportunistically target secondary interests in funds and companies”

Whereas most VCs making direct investments often operate with a relatively standard set of due diligence data generally provided to them by the target company or scrapped together through arduous primary research, Greenspring is able to track a range of relevant operating & financial data across a wide array of startup companies throughout its entire portfolio of VC fund investments. In effect, they can “cherry-pick” the best-of-breed companies with a strong degree of confidence during later stage funding rounds. Greenspring’s detailed, yet wide-ranging startup company insights across both quantitative & qualitative data, coupled with their ability to gain privileged access to arguably one of the most comprehensive & hard-to-access deal flow funnels via their fund investments, is an unparalleled advantage in achieving superior risk-adjusted returns within the VC space.

Select direct investments by Greenspring include:

Moreover, from an LPs perspective, by investing in one of Greenspring’s funds they are able to access the entirety of the VC investment spectrum from seed through secondary share sales. A highly efficient and effective “one-stop-shop”, if you will.

Now, all of this is not to suggest that Greenspring is the only firm in the world executing this model nor that this type of model is the optimal investing approach for all LPs. However, Greenspring is a pioneer in this regard with twenty years of proven success & $9.7Bn of committed capital - something is working.

Okay, so what exactly am I suggesting by sharing all of the above? We’ll keep it simple.

We believe there is a very timely opportunity to build the “Greenspring Associates of Japan” today. Whereas Greenspring sprang into existence during what some would argue was an inflection point for the U.S. VC ecosystem (i.e. out of the ashes of the late 90s VC bubble), the “Greenspring of Japan” would be born during what we feel is a very real inflection point within the Japanese VC ecosystem today: there is a proliferation of increasingly sophisticated VC GPs, an improving stock of domestic entrepreneurs & startups, an elevated call-to-action to support the industry from the Japanese government and a fast-growing pool of domestic capital flowing into the asset class.

Similar to Greenspring in the U.S., the firm would be able to build early relationships with the best of breed, emerging VCs in Japan today, supporting & growing with them as they scale, while earning the increasingly coveted opportunity to invest in their subsequent funds. Moreover, the firm would be a driving force in building out the later stage venture investment ecosystem in Japan, tapping into an up-until-now largely non-existent private asset class, while cementing itself as a leading, value-add player in the space, both among entrepreneurs (e.x. helping them expand abroad) & LPs, domestic & international.

Building such a firm today in Japan is akin to getting in at the “ground floor” of an eventual skyrise, after the foundation has been tested & proven to be primed for rapid development.

While we at Golden Southeast are primarily focused on our nuanced SMB acquisition strategy today, we would be eager to more deeply explore this vision with relevant partners interested in helping us build out this opportunity. Please reach out.

As always, we strongly encourage those with superior insights than us to reach out to correct any factual errors or misunderstandings we may have.