FW speaks with Kenneth G. Smith, a managing partner and leader of the Japan area Transaction Advisory Services practice at Ernst & Young, about M&A trends in Japan.
FW: What do you consider to be the major trends shaping Japanese M&A activity over the last 12 months?
Smith: In very general terms, the financial results of Japanese firms were near market expectations for the most recent year, primarily as a result of austerity measures. This has lifted management’s sentiment and determination to focus again on deals. Somewhat contrary to this trend is the persistently high yen, exacerbated partly by the eurozone crisis and the uncertainties surrounding the US economy, which has hurt exporters. This, in turn, is driving these export driven firms to consider further M&A abroad. This not only affects the OEMs, but the myriad of suppliers down the value chain. On a positive note, with the yen’s 25 percent to 50 percent appreciation from recent historical averages, assets overseas have become a bargain – for the moment. The persistent threat of slowdown in the domestic economy results in a continuing pressure on the bottom line. Some of these efforts led to consolidation, or domestic geographic expansion. Another trend is the beginning of an acceptance of carve-outs / divestitures of non-core businesses, or combination of such businesses with industry peers.
FW: What are the key factors driving recent domestic deal flow?
Smith: It appears that there is a trend for consolidation going on in several highly competitive sectors, for example in services, software / IT services, retail and wholesale. These industries, plus real estate, have always been in the top five active domestic industries for M&A over the last five years. An average deal size tends to be smaller, between US$20m and US$30m, indicating that these are typically a consolidation play. Many firms are also revisiting what is core versus non-core, an exercise that they have done several times over the past decade. A narrower view of this, especially for the larger firms, seems to be taking place. This has resulted in more entities now being considered for spin off or divestiture.
FW: Why are more Japanese companies looking abroad for assets?
Smith: The slow decline and aging population is driving many firms to look for greener pastures while there is still time to act. This trend is one in slow motion, but unless there are dramatic changes in immigration policy and patterns, it will be almost inevitable. These firms are buying either well known brands in new markets, or expanding their goods and services in the growing markets abroad. And the strong currency makes it easier to accomplish. A separate trend, caused by Japan’s lack of natural resources and last year’s tsunami, is an increase by major trading companies and utilities to procure a stable source of fuel and supply. With most nuclear generation stopped for the moment, base electric power output has shifted to hydrocarbons again. The trading companies have reaped great benefit from buying assets ranging from coal to LNG to oil-bearing tar sands. This uncertain electric power situation has also dampened domestic investment in new or upgraded manufacturing facilities. With a slowing domestic market for many of these products, difficulties in procuring workers, high labour costs, and the high yen, many manufacturers are continuing to elect an overseas solution.
FW: Do transactions seem to be concentrated in particular sectors, or is this activity spread across a range of industries?
Smith: If we look over the last 15 years, there have been some general observable trends in the players. Whereas the majority of M&A were manufacturing companies in the early to mid 1990s, the current landscape is approximately 30 percent each for manufacturers and non-manufacturers, 20 percent for trading companies and the rest financial services. Specifically, in the most recent years, general services, IT services, retail, wholesale, and logistics companies were the most frequent buyers. However, we note a longer ‘tail’ of industries that now participate in M&A activity. The number of deals in the energy and resources, and financial services sector tend to be less, however, deal sizes tend to be much larger, thus a different picture emerges when the size is factored in.
FW: Is Japan’s banking and finance environment open to supporting transactions? How are deals being funded?
Smith: In general, Japanese companies have sufficient cash for some level of transaction activity. Japanese financial institutions are eager to participate in the funding of deals, especially for cross-border deals. Domestically, however, due to the relatively depressed equity prices, lenders are not flocking to deals until this situation improves. However, as the number of Japanese borrowers declines and Japanese financial institutions continue to look for credible borrowers, they are open to supporting transactions as long as the clients are credible. Although the actual impact is as yet unknown, the Japanese government has recently extended a temporary financial assistance scheme for M&A activities as one of its strategic emergency measures to counter the yen’s rise.
FW: Could you provide some insight into the key issues for Japanese dealmakers when negotiating and closing M&A transactions?
Smith: Japanese dealmakers appear to be in one of two categories – seasoned pros or the unsophisticated buyers. The pros are, with little variance, not too much different from their western counterparts. There is some anecdotal evidence that the unsophisticated category is growing. For these buyers, there have been some challenges encountered along the way. At the risk of generalisation, these buyers tend to ask for too much detailed information during diligence, which places an additional burden on the seller to produce. Also, there is a tendency to require more time for analysis, internal approvals, etc., as compared to other buyers. This puts this group at a distinct disadvantage when it is a competitive situation. However, once these hurdles are cleared, Japanese buyers tend to be quite similar to other buyers.
FW: Have Japanese acquirers widened the scope of due diligence during M&A? Are they carefully evaluating aspects of the target company that could jeopardise their investment?
Smith: There have been some requests for procedures around such areas as pensions and IT, for example, above and beyond the traditional financial, tax and legal due diligence. However, we have more interest in these types of diligence from our non Japanese clients. There is still a tendency either not to do these types of procedures, or try to do them with in-house resources. Companies that have had trying experiences tend to be far more cautious in their diligence approach, and we have noted that the level of deal team experience at the client has improved over the last five years. There is also a trend where the same deal team works all the deals, as opposed to generalists in the finance department, for example.
FW: In your opinion, are Japanese acquirer’s doing enough to minimise transactional risk? What fundamental steps should they take, both in domestic deals and overseas?
Smith: In general, companies can always do more to minimise transaction risk. This begins with a good and honest understanding and assessment of the true synergies and deal logic, as opposed to hype. A robust analysis of the deal, expected synergies, expected costs, timeframe and person in charge should be identified up front. Also, depending on the industry, geography and other characteristics of the deal, specific diligence work streams could be used to minimise possible risk.
FW: What is your advice to Japanese buyers on planning for post-deal integration? How important is this process in unlocking future value?
Smith: We generally do not see adequate thought given to post-merger considerations for Japanese firms. We are continually amazed that a company can pay hundreds of millions, if not billions for a target, and have little or no plans on how to integrate. One key piece of advice is to plan early. The best time to plan is during diligence, where you can already begin to identify risk, and also synergy, areas. In addition, the client needs to identify its post merger team for the various functions to be integrated. Lastly, there needs to be a mechanism to track and measure specific KPIs to ensure that the synergies are indeed being recognised – otherwise, how would you know you have actually captured the synergies that you stated at the beginning of the journey? Finally, for Japanese firms, there is an imperative to develop a cadre of managers who are capable of conducting business overseas. A multi-billion dollar deal is great, but if you do not have the ‘A Team’ to send, there may be better ways to spend your money.
FW: What are your expectations for Japanese M&A, both domestic and outbound, over the coming months?
Smith: With the big caveat that the yen will stay where it is, we expect a continuing rise in outbound deals. There will be an increasing number of smaller to mid-sized firms going outbound than before. Domestic deals will stay flat or slightly decline, but we believe these would be firms who elect to stay domestic to merge. We may also see some change in the flow of investment capital vis-à-vis changing inter-country dynamics, both from a business and political perspective. Slowdown in a previously high flying geographic investment destination will most certainly result in a rethink of geographic allocation and concentration risk standpoint. Also requiring close monitoring is how the recent political showmanship regarding disputed territories and rhetoric around past historical differences will need to be factored into the investment decision making process.
Kenneth G. Smith is a managing partner and leader of the Japan area Transaction Advisory Services practice at Ernst & Young. He has 25 years of experience in management consulting and transaction advisory services in North America and Asia, focused around M&A, post merger integration, and operational process improvement initiatives. He also had operational experiences as an officer in a private equity firm’s portfolio company. His industry experience includes IT/communication, energy, financial services, and manufacturing. Mr Smith is bilingual in English and Japanese, and has been in Tokyo since 1996. He can be contacted +81 3 4582 6663 or by email: email@example.com.
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Kenneth G. Smith
Ernst & Young