“Private Equity” Investing With Venture-Like Returns…In Japan

There exists a highly compelling opportunity in Japan today for forward-thinking investors to back a small group of savvy global entrepreneurs focused on an overlooked “private equity” strategy that would allow them to achieve venture capital like returns — think 25x or more over a decade — with a fraction of the risk typically accompanying investments in technology startups.

To succinctly summarize the thesis, rather than betting on an array of technology moonshot (hopeful) home-runs, one instead backs a team focused on high probability singles — acquiring proven, low-growth, stable & cash generative small businesses (“SMBs”) from the hundreds of thousands of retiring SMB owners around Japan. When viewed as a growing, diverse portfolio, these cash-flowing SMBs become a durable, consistent & increasing high-yield cash annuity.

(Sidenote: let’s consider SMBs to mean $500K to $2.5M in annual “cash earnings”)

So, where do the “venture-like” returns come from then? This doesn’t sound like a unicorn-esque investment strategy, right? Well, unlike in most other developed markets, very small businesses can IPO on the Japanese stock market (note: IPO’ing is not the answer in and of itself)— it is not uncommon to see businesses with $10M in revenue and $1.5M in earnings sell shares to the public (check out Tokyo IPO for more details). While most international investors & businesspeople will scoff at this premature liquidity seeking strategy, there are distinct Japan specific benefits to IPO’ing so early, which I’ll touch on later. Tying this back to the prospect of “25x returns”, I will briefly outline below the broader SMB opportunity set in Japan + why & how being publicly listed would likely provide early investors massive returns over an ensuing decade with a focused, skilled management team at the helm. We’ll call our hypothetical publicly listed SMB acquisition vehicle NewCo for the purposes of this post.

(Quick sidenote: I would point readers to the likes of Constellation Software, Indutrade or AddLife who have arguably perfected the art of buying SMBs in their respective verticals & are valued accordingly in the public markets today)

All things considered, Japan offers the best risk-adjusted opportunity in the world to acquire cash generative SMBs. For starters, simple statistics reveal the massive supply / demand imbalance:

“Over-Supply”

- 50% of SMBs with owners >60 years old are looking for, but are unable to find a successor

- 2.4M SMBs (>60% of all SMBs) will be run by managers aged 70 or older by 2025

- Nearly 70% of SMB owners over the age of 70 are currently unable to identify a successor. (Quick math: almost 1.7M SMBs will likely have no succession / exit liquidity possibility for their current owners by 2025…)

- Roughly half of SMBs that go out of business each year do so despite being profitable. If unchecked, this equates to 6.5M jobs & ~$205 billion in GDP by 2025

- To drill into a core “target” opportunity set, let’s take a look at an informative graphic from a leading (publicly listed) SMB M&A advisory firm in Japan, Nihon M&A Center:

“Limited Demand” / Few Buyers

- Japan’s population has been and continues to rapidly decline. By definition, this only exacerbates the successor dilemma. (Sidenote: to be saved for another discussion, but it is my strong (contrarian) view that Japan will aggressively open up its immigration policies over the next 10 to 20 years, igniting a relative resurgence of growth & economic dynamism)

- Generally speaking, Japanese are an inherently risk averse population and thus, as a whole, have relatively fewer entrepreneurs, particularly those seeking to acquire & manage SMBs (vs. building a technology startup). To better highlight this risk averse nature, Japanese hold roughly $9 trillion of their aggregate $17 trillion in financial assets in cash (as of Sept. 2018).

Source: Bank of Japan Flow of Funds Accounts: Federal Reserve Board Financial Accounts of the United States; ECB Euro Area Accounts

- While private equity in Japan has been more recently growing, the focus remains almost exclusively on deals well above $25M…so not at all touching the target market for NewCo’s strategy (i.e. $2M to $25M deal size). Additionally, private asset investment in Japan, particularly outside of real estate, remains quite limited in comparison to global peers such as the U.S. & the U.K.

There exists an (over-)abundance of capital in Japan earning extremely low yields given near-zero / negative interest rates. This will likely (need to) continue for quite some time.

Similar to the Japanese consumer, the typical capital structure of a Japanese corporate, big or small, is often defined by an overcapitalized balance sheet with significant, arguably irrational, levels of excess cash. This is predominately driven by a lasting cultural conservatism among business executives coming out of the bubble period of the late 1980’s (sidenote: the Japanese government + a growing number of activist investors are driving changes here…albeit at a slow pace).

Culturally & generally speaking, Japanese SMB owners are far less focused on maximizing exit valuations, as is often the case in the U.S., and far more interested in the ongoing well being of their employees, customers and suppliers.

Given the above two points (i.e. overcapitalized balance sheets & a focus on business continuity vs. valuation maximization) coupled with NewCo’s target acquisition profile (i.e. low to no-growth), SMBs can very likely be acquired for 1.0x to 2.0x, net of cash, in some cases

(Sidenote: as a point of reference, typical SMB acquisitions in the U.S. fall within the below acquisition multiple ranges)

Source: Pepperdine Business School

This one may require further exploration, however, performance-based incentive compensation is not practiced as “authentically” as one would expect in most Japanese companies (i.e. bonuses are more or less guaranteed regardless of performance in a lot of cases). NewCo would likely look to introduce a stronger degree of performance based compensation for individual SMB General Managers at the very least. Presumably, with very transparent, straight-forward, and clearly measured metrics / goals, one could likely then expect to drive greater efficiencies and improved productivity within portfolio companies, while also leveraging this differentiated, highly competitive monetary upside as a powerful recruiting tool within a Japanese job market defined by labor shortages.

(Sidenote: at its core, NewCo’s business model is focused more so on driving value creation via astute (i.e. cheap) acquisitions of stable cash flow streams (in the form of SMBs) vs. turning around poor businesses or discovering “hidden growth gems”…the latter of which are generally targeted by “search funds”)

As initially mentioned, IPOs in Japan are common at very small sizes unlike in most all other developed markets (e.x. IPOs where a company has just $1M to $3M in earnings with $10M in revenue is viable & frankly more common than one would expect). Partly driving this are the numerous advantages to being a public company in Japan:

According to a 2016 Teikoku Data Bank survey, the top reasons to IPO in Japan were:

- 72% — improve name recognition or credibility

- 66% — recruit (talented) employees

- 53% — improve financing capabilities

Once publicly listed, a premium valuation (if today’s Japanese “high-growth” small cap multiples are to be used, one could except a P/E multiple of anywhere from 25x to 50x) would likely be warranted for NewCo in light of the following:

- There is no comparable liquid asset available to the investing public today

- NewCo would be a higher growth business both on the top-line & on a cash flow basis (with much of that earned by way of acquisitions of course)

-Most listed companies in Japan are predominately domestic facing. Something not yet mentioned, but certainly to be pursued by NewCo management would be to acquire SMBs elsewhere around the globe, say, in the U.S. alongside their Japanese efforts. Investors in the Japanese market, where NewCo would be listed, would most likely ascribe a premium to the shares as a result of the increasingly diversified multi-currency cash flow stream (sidenote: this is important for investors in Japan as the broader market story is a declining domestic population, low-growth economy, etc. So the more global one’s earnings, the better)

- Few listed companies in Japan provide shareholders with a transparent, timely view into their businesses. Even fewer have investor relations efforts that adequately cater to international investors. NewCo would have an extensive focus on communicating on behalf of & promoting the business both domestically & internationally (i.e. in Japanese & English) with a significant amount of transparency (investor meetings, earnings call transcripts in both Japanese & English, etc.)

- As briefly noted above, few listed Japanese companies adhere to rational / intelligent capital allocation strategies, such as employing share buybacks, dividends or special dividends; most today simply hoard cash or pursue questionable investments that oftentimes do more harm than good for investors (e.x. acquire non-essential, low-yielding real estate vs. returning cash to shareholders). NewCo would be incredibly focused on prudent capital allocation strategies, following in the footsteps of Warren Buffett of Berkshire Hathaway, Henry Singleton of Teledyne and Nicholas Howley of Transdigm

Lastly, there would almost certainly be a valuation arbitrage opportunity— NewCo would acquire individual SMBs at anywhere from 1x to 5x earnings, while itself being valued in the public market at a meaningfully higher multiple given its far greater size & growing, increasingly diversified portfolio of SMBs.

So…you’re probably asking yourself…well, how do we invest in something like this? Fortunately, we’ll look to share more in a coming post about a broader blueprint of sorts that will help to answer that exact question! Hint: we start in the U.S….