American VCs Land in Japan New laws and cultural changes fuel Western interest –

When Alan Patricof flew to Tokyo about two years ago to scout the market for venture capital opportunities, he brought back some good news: The time had finally come for Patricof & Co. Ventures Inc. to open its doors to Japan.

Patricof & Co. already had offices in London, Paris, Madrid, Milan and Tel Aviv, among other cities, but legal and cultural barriers had largely kept Japan out of reach for American and European venture firms. However, recent revisions in the Japanese legal and tax codes, coupled with cultural changes, have created an environment that now supports entrepreneurial activity. And a handful of American venture firms are slowly opening offices there to take advantage of the growing deal flow, particularly in the information technology sector.

“It was a major breakthrough,” Patricof says. “From my standpoint, I saw a society changing; I saw the culture opening up. I saw risk-taking starting to be somewhat obvious, and I saw a chance to form a venture firm that could really perform the way Americans do.”

Patricof officially opened its first Asia office in Tokyo a few months ago, along with local venture capitalist Yoshito Hori, and the Apax Globis Japan Fund LP held a final close on $180 million in March, with capital from U.S, European and Japanese limited partners. At press time, the vehicle, which will back only Japanese companies, had closed five IT deals, putting to work about 15% of the fund, Patricof says.

Other key venture players that have traveled across the Pacific in the last 12 to 18 months include J.H. Whitney & Co., Walden International Investment Group, Warburg Pincus, H&Q Asia Pacific and the U.K.’s 3i Group PLC.

J.H. Whitney, an investor in Internet, telecom and financial services enterprises, set up shop in Tokyo in March 1999, headed by Managing Director Paul Slawson. The venture firm’s J.H. Whitney IV LP, a $1 billion global fund that closed last December, has allocated $300 million for investments in Asia and Europe and has already invested $100 million in Japan, Slawson says.

H&Q closed its Asia Pacific Growth Fund III in January, and to date, the vehicle has invested a total of $225 million in 10 Japanese companies and is inching very close to the fund’s 30% investment cap per country, says Ta-Lin Hsu, chairman of the firm. The fund will back solely Internet-related companies in the media, business-to business e-commerce and wireless sectors.

Walden International will shortly hold a $30 million first close on its Walden Japan IT Fund, which is expected to wrap on $200 million and back Internet companies in the B2B and telecom service sectors, says Lip-Bu Tan, the firm’s chairman, who anticipates attaining 25% to 50% returns in Japan, as Walden does in other parts of Asia.

As American VCs have made their way to Japan, venture investing has turned into a hybrid between old and new practices, with traditional Japanese firms learning the ropes from their Western counterparts. J.H. Whitney, for instance, co-invests with American, as well as Japanese firms such as Jafco (Japan Associated Financial Co.), an affiliate of Nomura Securities, and Softbank Inc. Unlike the past, Jafco now accepts board seats on some of its portfolio companies and helps to build their businesses. In structuring their deals, the firm also has moved beyond common stock to begin taking preferred stock in their portfolio companies.

“It’s not that U.S. practices are coming to Japan, it’s just that the best practices in the most competitive market – which happens to be the U.S. – are coming to Japan,” Slawson says. “And that’s more shareholder protection, more accountability and rigor in terms of analysis, and the monitoring and building of companies. That’s got to be a good thing.”

How Things Have Changed

Indeed, venture investing has existed in the Land of the Rising Sun for decades, but there were key differences in the way it was practiced.

“The reason I didn’t do anything here for years is because the laws did not allow what I thought was an appropriate environment to make money as a venture capitalist,” Patricof says in a recent telephone interview from Tokyo while attending an annual staff meeting.

Unlike independent venture firms in the U.S., Japanese-run firms were affiliates of commercial banks, securities firms, trading companies and life insurance companies. The primary goal of Japanese-style venture capital was not to achieve the highest return on investment but rather to increase the business of a parent company. A bank, for example, would typically back companies to which it could eventually extend loans, and a securities firm would invest in enterprises that might need investment banking services somewhere down the road.

And while it’s common practice for American VCs to take large stakes in about 30 to 40 portfolio companies, sit on their boards and adopt a very hands-on approach to developing their enterprises, traditional Japanese VCs often took small stakes in as many as 100 portfolio companies and invested in later-stage enterprises that were preparing to go public because they were averse to risk, Hsu says. Japanese VCs also had no real investor rights or close involvement with any of the companies they invested in, and in many cases, they only received annual reports, he adds.

“It wasn’t venture capital in the classic sense, which was business building,” Slawson says. “It was rather a form of betting, so there wasn’t assistance given to management. In fact, [Japanese] venture capitalists refused to sit on the boards of these companies because it wasn’t worth their time, and because they had hundreds of these million-dollar shot investments.”

While there are roughly 150 Japanese-run venture capital firms, only a handful continue to dominate the landscape. Jafco is the largest, with $1.5 billion under management, followed by Nippon Investment Finance, an affiliate of Daiwa Securities, with $720 million, and Nikko Capital, with $252 million, according to documents from Patricof & Co. Softbank and Hikari Tsushin Inc. are two other major Japanese players.

Slawson says the changes in Japan are a direct result of the desire to recreate the wealth in the U.S. and Europe from the surge in Internet-related companies. “This whole wealth-creation phenomenon happened very quickly around the world, and it caught conservative Japan flat-footed,” he says.

At the same time, Japan’s prolonged economic downturn has forced many large corporations to abandon their traditional lifetime employment practices and for the first time lay off workers. The country’s 4% to 5% unemployment rate, the highest in the post-war era, has also promoted an entrepreneurial way of thinking in order to survive.

Meanwhile, Japan has 17 million Internet users, second largest in the world, representing a huge market for IT companies to profit as they have in the West. A number of recent success stories among Japanese companies have certainly sparked other wannabes. NTT DoCoMo, for example, which began as a tiny division of Nippon Telegraph and Telephone Corp. (NTT), is now larger than its parent company. The broadband network company IJJ is now worth $3 billion, and Inter Q, an Internet service provider, is worth $5 billion. Masayoshi Son, the president and CEO of Softbank, and Yasumitsu Shigeta of Hikari are just a few examples of successful millionaire entrepreneurs.

“The Internet is driving the New Economy, so that’s why I think you’re seeing a lot of venture capital firms starting to go to Japan,” says Walden’s Tan, who predicts B2B will be the hottest sector in Japan because it’s home to the leading manufacturers of everything from DVDs to notebook computers.

Government Intervention

Perhaps the most important change in Japan was the government’s move to modify a series of laws and regulations that encourage Western-style venture capital. High on that list was the recent loosening of strict regulations for getting listed on the Tokyo Stock Exchange and Jasdaq. Companies no longer needed three years of consistent earnings to have an IPO, and the average age of a company going public was significantly reduced from its 20-year average, Patricof says. Telecom deregulation has also made it possible for companies like competitive local exchange carriers (CLECs) to compete in the open market.

“There wouldn’t be one biotech or one Internet company that could go public in an environment where you had to have three years of consistent earnings, so that eliminated an awful lot of high-technology [companies],” Patricof says. Indeed, Microsoft Corp., Intel Corp., Yahoo! Inc. and Inc. all went public with no earnings, and in some cases, with no revenue.

In 1998, the government adopted the Japanese Limited Partnership Act for Venture Capital Investments, for the first time establishing limited liability partnerships. Previously, there was reluctance to invest in small businesses because investors were concerned about liability extending beyond the actual amount invested.

In addition, the Ministry of International Trade and Investment (MITI) created a division to promote venture capital, providing grants of up to $500,000 for start-ups and for Japanese VCs to train abroad. New laws now permit company stock options for employees, venture partners to sit on the boards of their portfolio companies and corporate pension funds to invest in venture capital through managed funds, Patricof says. The U.S. government first opened the doors for private pension funds to invest in VC in 1977, and they now make up the largest portion of the venture fund-raising pie, according to Venture Economics.

The Japanese government also removed the 50% cap on owning shares of a portfolio company. Japan, however, has yet to adopt the Generally Acceptable Principles of Accounting (GAAP) used by most of the Western world.

“Japan is going through a reinvention of itself and a restructuring,” Tan says. “They are starting to realize that the old system is not working, and they need to make some changes … [but] it took them a while to figure out the way they should change.”

Despite some giant steps forward, there are still obstacles to venture investing in Japan. Tan says the country still operates as an “old boys network,” and the need for local contacts is extremely important. Before establishing a presence in Japan last year, Walden formed strategic alliances with limited partners such as Sumitomo Trading Co., Nikko Capital and Fujitsu Corp., one of the largest makers of telecom equipment. Fujitsu is the firm’s largest LP, making up half of its $30 million Walden Japan IT Fund.

Patricof says comprehensive due diligence remains a foreign concept in Japan, but his firm managed to overcome those hurdles twice recently, investing $7 million for a 51% interest in Pasona Tech, an online and offline employment agency, and $3.5 million in a software company, Works Application. APAX Globis was able to obtain provisions in its term sheets for getting monthly reports and for holding regular management meetings, he says.

Slawson, who speaks fluent Japanese, says venture capital skills are simply not enough to navigate through the nuances of Japanese culture. Those distinctions can mean asking direct business questions and failing to get clear answers.

“Then you wonder if you didn’t get the question across correctly, or whether they understand the question but don’t have an answer, or they do, but they don’t want to tell you,” he says, adding that most of the time it’s because they don’t have an answer and are embarrassed to admit it.

Such muddled thinking and indecisiveness can throw a monkey wrench into a deal, because ultimately, a venture firm is accountable to its limited partners, Slawson says.

“A lot of the time you get a lot of Belgian action here – waffling – and it’s unacceptable, and it’s not what we tolerate,” he adds. “And you just decline to invest in those people.”

Sample of VC Firms in Japan


Japan/America Ventures, Inc. 192 90949 473.7 94.6 93

Undisclosed Venture Firm 38 225985 5947 0.5 0.8

Cross Atlantic Partners 21 3411 162.4 15 1.3

(Hambro International Equity)

Partech International 16 2400 150 9.6 0.9

Pacific Technology Ventures 6 966.7 161.1 21.4 8.2

SIT Investment Associates, Inc. 6 5573 928.8 14.3 17.8

H&Q Asia Pacific, Ltd. 2 7154 3577 4.7 2.7

Undisclosed Non Venture Firm 2 2787 1393.5 0.1 0

APV Technology Partners 1 605 605 3.7 0.6

Advent International Corp. 1 513 513 0.3 0

Hambrecht & Quist Venture Associates 1 346 346 1.5 0.1

Lubar & Co. 1 0 0 5.9 0

NIF Ventures USA, Inc. 1 150 150 5.6 0.6

(Nippon Investment & Finance Co., Ltd.)

Undisclosed Corporate Investor 1 605 605 0.2 0

Telos Venture Partners 1 150 150 4.8 0.4

Technology Venture Investors 1 1024 1024 0.8 0.3

Smithkline Beecham Corp. (S.R. One) 1 0 0 2.9 0

SOFTBANK Capital Partners 1 2750 2750 11.1 1

S.R. One Limited 1 25 25 2.3 0

Patricof & Co. Ventures, Inc. 1 16000 16000 0.3 0.9

Palmer Partners, L.P. 1 37 37 1.3 0

Yasuda Enterprise Development Co., Ltd.1 150 150 3.1 0.5

(Nippon Ent.Dev)

Olivetti Management of America 1 366.7 366.7 1.5 0.3

Maryland Venture Capital Trust 1 500 500 8.3 3.6

Kleiner Perkins Caufield & Byers 1 1455 1455 0.2 0.1

HarbourVest Partners, LLC. 1 991 991 0.3 0.1

Goldman, Sachs & Co. 1 12000 12000 0.4 0.4

Doll Capital Management 1 1001 1001 3.3 1.1

Arbor Partners LLC 1 605 605 10 3.6

Source: Venture Economics

Top vc industries in japan



Consumer Related 80 171.93

Industrial/Energy 27 25.606

Semiconductors/Other 21 68.241

Computer Software 19 85.9

Manufacturing 17 66.671

Construction 14 113.898

Other 14 3.822

Computer Hardware 13 10.303

Business Service 10 66.522

Fin/Insur/RealEstate 10 20.058

Medical/Health 9 2.887

Communications 6 13.336

Transportation 4 0.438

Biotechnology 2 0.573

Agr/Forestr/Fish 1 21.228

Computer Other 1 3.074

Utilities 1 0.24

Internet Specific 1 11

Source: Venture Economics