On the cusp of breakout growth, the Japanese private equity (PE) industry is an object lesson in the art of perseverance. After a long buildup, the industry has acquired the capabilities and competitive edge required to play a more prominent role in Japan’s financial landscape. But to complete the journey, industry participants need to take some final critical steps.
The private equity industry has faced several structural headwinds in its attempts to scale in Japan. These include historically lower levels of M&A and a cultural context in which businesses are often held by families or in tighter ownership structures. But that is starting to change, as shown by the recent $15 billion PE buyout of industrial giant Toshiba, one of the largest global PE deals in the past five years. To build on that foundation, the industry can play an important role—fostering understanding of the benefits of PE, promoting the interests of shareholders, and attracting new deals.
What has put Japanese PE on a more positive trajectory? First, higher volumes of capital are earmarked for longer-term risk-taking. In addition, the talent pool is expanding, enabling firms to engage more effectively with opportunities. Third, there is a sharpening focus on shareholder value, alongside the interests of managers and employees. Moreover, amid generally subdued public-market performance, more financial-market professionals and policy makers see PE investment as a way to enhance return on capital and boost labor productivity and competitiveness.
While recent evidence suggests the PE industry in Japan is headed in a positive direction, there’s potential for further progress. In this paper, we discuss how new approaches to deal with sourcing, storytelling, and value creation could reinforce the case for PE and lay the groundwork for a successful expansion of the asset class.
Glass half full
From a glass-half-full perspective, the Japanese PE industry is riding the crest of a wave. The years 2021 and 2022 were the biggest ever in terms of deal activity, and momentum continued into 2023, with several global PE and sovereign wealth funds entering the market (Exhibit 1). Given the recent increase in valuations, companies are more willing to consider acquisitions by PE funds, especially founder-owned companies looking for exit opportunities. Moreover, considering Japan’s low-interest-rate situation, valuations for Japanese stocks remain attractive, even after the recent price appreciation, suggesting buying opportunities abound for PE funds. The increase of activist campaigns in Japan has also influenced the market. More companies are actively considering restructuring, leading to additional carve-out opportunities. Hostile takeovers may also increase, as companies place more emphasis on shareholder value. Companies may seriously consider private equity bids, unsolicited or otherwise, if selling a subsidiary would improve their capital efficiency. This may increase the chances of PE firms becoming a white knight and winning deals.
Conversely, from a glass-half-empty perspective, the picture looks a little different, with the market still some distance from reaching its potential. The number of large PE exits remains low (there have been only nine deals with an exit value higher than $1 billion since 2010, compared with 464 in the United States). In addition, transactions have tended to focus on subsidiary sales or carve-outs of noncore assets (Exhibit 2). Of the ten closed private equity deals worth more than ¥100 billion ($670 million) since 2020, six fit this description. This suggests significant potential for other deal types, including acquisitions of independent publicly traded and privately held companies. Furthermore, there are few examples of successful large transformations under PE ownership. In light of these dynamics, the industry has a tremendous future ahead.
Looking to the next generation of PE investment in Japan, the most successful international and domestic firms will seek to create an investment process that fully reflects local conditions. They will also bring a clarity of vision to convert doubters and, of course, generate reliably convincing results. We believe this quality of execution will reflect four strategic priorities:
- deploying a thematic investment approach to pursue attractive companies, particularly publicly traded businesses in need of new capital, ideas, and expertise
- sharpening the narrative for influential stakeholders in Japan’s corporate ecosystem
- continuing to build out a holistic value creation playbook customized for Japan
- pursuing investment opportunities in growth-stage companies
Here we examine each of these priorities and gather examples of how leading players are shaping their strategies and capabilities to take advantage.
1. Deploy a thematic investment approach to pursue attractive companies
To create win–win deal opportunities, PE funds need to adopt more thematic approaches, developing points of view on industries aligned to structural economic tailwinds and then working to build relationships with relevant companies. McKinsey analysis shows that Japan PE transactions from 2010 to 2023 were more oriented toward retail, consumer, and industrial sectors than those in the United States and Europe. There was less focus on typically higher-growth sectors such as technology, media, and healthcare, which are often attractive to PE in other geographies (Exhibit 3).
It may be that a narrow industry scope has limited the growth of PE in Japan. In fact, public companies in the technology, media, and healthcare sectors generated the best total shareholder returns (TSR) during the 2010–23 period, suggesting PE firms would have been better served in those sectors (Exhibit 4). One exception in terms of activity was IT hardware, where there were several deals. However, in general, there is room to increase capital allocation to the most attractive industry verticals.
Private equity may also find opportunities in public-to-private deals, particularly where there are companies with solid fundamentals that would benefit from capital, expertise, and incentives. In the public markets, there are certainly many companies with relatively stagnant levels of performance. Among 1,949 companies listed on the Tokyo Stock Exchange, only 22 percent achieved more than 5 percent annual TSR growth over the past five years (2017–22), McKinsey research shows.1
For many Japanese companies, management and business reforms to improve competitiveness can be a key unlock for value creation. Take-private deals may be an enabling step, which we describe in more depth below.
2. Sharpen the narrative for influential stakeholders
PE firms in Japan have an opportunity to tell better stories to their stakeholders. A key focus should be to highlight the potential for upward mobility and financial rewards for employees of PE-owned businesses, playing into a cultural context highly focused on status and prestige. It would also make sense to accentuate the potential role PE firms can play to improve overall capital allocation and productivity:
Boosting employee motivation and productivity through financial rewards. Employees in Japan are increasingly adopting a mindset focused on upward mobility and financial rewards. This is reflected in job switch rates, which have accelerated in the wake of the pandemic. The proportion of annual switches was 7.6 percent in 2022, compared with 3.7 percent in 2016. Primary reasons cited include low salary (13 percent) and human relations (9 percent).
Historically, employee engagement in Japan was among the lowest in the world.2 PE-owned companies that address this issue have an opportunity to develop a powerful alternative proposition to drive performance. In fact, a select cohort of Japanese companies with “high” levels of employee engagement saw their stock prices rise by 65 percent over a five-month period, while companies with “low” levels of engagement saw only 15 percent gains, according to one survey.3 Among the numerous levers investors can use to improve employee motivation are modernizing performance evaluation systems to create clear policies on merit-based promotion and distributing equity to key performers.
Regulatory emphasis on capital efficiency. The Tokyo Stock Exchange rules include a provision that requires listed companies to maintain mandated price-to-book (P/B) ratios, with delisting threatened if they fail to comply. In a similar vein, Japan’s Ministry of Economy, Trade and Industry (METI) has published a report identifying improvement drivers, including capital efficiency and growth potential. METI provides case studies of foreign investment in Japanese companies and highlights the Japanese government’s active efforts to attract foreign talent and investment (by promoting highly skilled foreign personnel and encouraging direct investment). It recognizes the recent increase of M&A activity through foreign PE funds.
These initiatives are important because more than 40 percent of Japanese companies in the TOPIX 500 Index have P/B ratios below one. This compares with just 5 percent of companies in the S&P 500 Index and 24 percent in the Bloomberg European 500 Index. PE’s emphasis on productive use of capital aligns well with Japan’s effort to improve financial metrics in public companies.
3. Continue to build out a holistic value creation playbook customized for Japan
PE firms achieve their core objectives when they embed value creation capabilities in the companies they buy. In Japan, they can achieve this by stepping up across three dimensions: closing the digital gap, accessing untapped opportunities overseas, and enhancing business-building and innovation capabilities:
- Seek out companies in need of stronger digital and AI capabilities and guide their transformation.
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Japan ranks 29th out of 63 countries in the 2022 IMD World Digital Competitiveness Ranking, after four consecutive years of declines. Furthermore, only 34 percent of business leaders in Japan believe their companies are ready to promote digital, compared with 57 percent in Germany and 83 percent in the United States.4
The digital priorities for a given company will be based on the context in which it operates. Starting in the due diligence phase, investors should evaluate how digital and AI could impact the business. They can then plan initiatives that reflect the company’s business priorities and minimize the risk of disruption. As majority shareholders, PE owners can be catalysts for improvements in areas such as back-office processes, analytics (transaction pricing, salesforce deployment), and generative AI, which can support enhanced customer service, agile marketing, and product development.
To deliver on this agenda, PE should be willing to play an active role in guiding management teams. This would require not only expertise in digital and AI but also change-management capabilities, leveraging in-house or external expertise.
- Strengthen innovation capabilities to create new sources of revenue.
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Digital and AI capabilities can be harnessed both to foster productivity and deliver incremental revenue. By investing in capabilities, PE firms can help companies establish new services and business models, strengthen customer relationships, and boost performance.
Japan has a strong innovation culture, yet there is potential for companies to create new revenue streams from the value they create for customers. Markets outside of Japan have seen a business model shift away from onetime sales to ongoing services that better address customer needs—the so-called subscription model, which in public markets is associated with higher valuations. Perhaps for this reason, many Japanese companies are already moving in this direction. The Japan subscription market now generates around ¥1 trillion ($700 billion) in annual income, amid growth of 9 to 11 percent from 2020 to 2022 (CAGR), and we expect this momentum to continue.5
- Accelerate international growth and competitiveness.
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Many Japanese companies are “underweight” in overseas revenues, reflecting a focus on the opportunities available at home as well as a culture of risk aversion. As a percentage of GDP, Japanese exports are lower than any country except the United States. A particular challenge may relate to talent and organizational design: when asked in a recent survey if they had sufficient talent to operate overseas, 70 percent of Japanese companies said “no” or “most likely no.”6 Given their access to global talent across extensive networks, PE firms are ideally placed to help companies overcome these challenges.
4. Pursue investment opportunities in growth-stage companies.
PE funds are starting to consider growth investment opportunities in earlier-stage companies. The need for start-up financing in Japan is accelerating and has grown to a scale of more than ¥900 billion ($634 billion) since 2022. On the other hand, the number of IPOs has not shown consistent growth, rising from 102 in 2020 to 136 in 2021, and then hovering in the 110s since 2022. In addition, recent examples of IPOs reveal that some companies have taken more than 20 years from inception to achieve an IPO, and the number of cases where the IPO application period exceeds one year is increasing. Based on this investment environment, there are companies with growth potential that have capital needs. PE funds are pursuing this opportunity to inject growth capital, providing means for VC funds to exit and for the start-up company to accelerate its growth.
What should PE investors do next?
Japanese private equity is a growing presence in the financial landscape. But the industry still has an opportunity to grow. Many Japanese companies could benefit from increased digitalization, internationalization, and reinforcement of recurring-revenue business models—all of which PE firms could bring to the table.
PE could also create value by aligning with emerging trends, such as the desire among employees for upward mobility and engagement. Higher levels of engagement are associated with increased financial returns in both publicly and privately held companies. The message for PE decision makers? If they make bold decisions and execute effectively, they can drive productive change and create a winning proposition for stakeholders across the corporate ecosystem.
