Country Focus: As Deregulation Efforts Continue in Japan, Foreign VCs Impact Industry –

The Japanese call it gaiatsu or literally “foreign pressure.” It wasn’t that long ago the Japanese watched their ecomony slump into a recession while the U.S. economy entered an era of unprecedented growth and prosperity. During that time, the Japanese government struggled to find the right levers to jump start the economic engine that was once the envy of the rest of the world.

The Japanese felt gaiatsu – not only from the U.S., but also from other Asian countries – South Korea, Taiwan and Singapore – with strong technology infrastructures. With these countries aggressively developing their own venture capital industries, it has encouraged the Japanese government to consider its own venture industry as one possible lever that will lead it to recovery.

“The Japanese government has been working hard to deregulate the issues surrounding venture capital,” says Yoshito Hori, chairman and chief executive officer of Apax Globis Partners & Co. “Before 1995, VC’s were not allowed to sit on the board of portfolio companies, limited partnerships were not allowed, pension funds were not allowed to invest into venture capital funds, and there were no stock options allowed.” Hori adds since 1995/1996, the government enforced deregulatory efforts. “[Now] the environment and conditions are almost identical to the U.S.”

With the introduction of such reforms as the creation of Jasdaq and Mothers (or Market of the High-growth and Emerging Stocks) that allow for easier company listing, the introduction of stock options in employee compensation plans and the passing of the Limited Partnership Act, the industry has witnessed considerable growth. According to a study commissioned to Venture Economics by the Japanese Ministry of Economy, Trade and Industry, a record 48 funds raised over 164 billion ($1.34 billion) in the first half of 2000, far outpacing the 30 funds that raised 113.7 billion in all of 1999. The Nihon Keizai Shimbun reported that investments by VC firms reached a record 420.1 billion in the fiscal 2000 year, which ended in March breaking the previous record of 299 billion in fiscal 1999.

But while it may have gotten easier to make investments from a regulatory standpoint, according to Paul Slawson, managing director of Whitney & Co. Japan, “there are still a lot of problems, so we’re not out of the woods yet.” Citing differences in rules governing the use of convertible preferred shares to differences in investment styles, Slawson believes that foreign VC’s such as Whitney, H&Q Asia Pacific and Warburg Pincus are helping to introduce standard practices in areas such as valuation metrics and corporate governance that just were not done in Japan before. “People said what we were doing was illegal, and from a custom standpoint these were things that just were not done,” says Slawson. “Now it’s standard practice.”

Seeking to capitalize on this foreign expertise and improved regulatory environment, Japan’s Old Economy companies such as Itochu, Marubeni, Orix and NEC have emerged as active investors in the venture realm as well. “One of the major reasons why trading companies like Itochu started [venture arms] is that we are exporting and importing and doing offshore trading, and we are engaged in commodity flows internationally,” says Hank Sakai, Sr. vice president of Itochu Canada. “For us, we have to find some new opportunities . . . Our strength is that we know the smaller venture businesses but we do not know how to evaluate them, or how to take them public.” For Sakai, this means partnering with U.S. and European VCs to learn from their expertise.

“We feel this is a positive [trend], simply because in the past Japanese companies had not invested in Japanese companies. They invested only in Silicon Valley companies,” says Hori. “Now, we are seeing the phenomena of Japanese companies investing in Japanese entrepreneurial companies. This is making these companies more and more visible and accessible to bigger companies, which means more access to capital. We feel this is positive.”

Mixed Results in Dotcom Aftermath

As in other parts of the world, VCs practicing in Japan have become much more circumspect about their investments. “The Internet bubble has burst, but strong technology companies are selectively invested in by VCs. So it’s a mixed environment now,” says Hori. “The economy is not going up, but deregulation is still occuring.”

According to Venture Economics, disbursements into Japanese companies fell sharply to $405 million in the first half of 2001 compared with $1.3 billion disbursed in the first half of 2000.

Despite the dotcom collapse, Hori sees an upward trend in entrepreneurship in Japan especially in the wireless sector. “In Japan, we have more than 30 million users of mobile Internet and it has been very hot,” notes Hori. “At the same time, we’re also looking at more and more mobile phone component companies like AP1, which produces geomagnetic sensors to be incorporated into PDAs and mobile phones.” Hori also sees promise in broadband especially fiber optics. “I believe fiber to the home will happen first in Japan.” Apax has invested up to $55 million into 13 portfolio companies, according to Hori.

Fund raising has become especially challenging since the primary source of capital has usually come from insurance companies, banks, securities firms and corporations, which were hit hard by the poor economy.

“Fund raising globally has become very difficult and Japan is no exception,” says Slawson. “The type of funds that are getting raised here are not tech funds, but restructuring funds. Most LP’s are pretty skeptical about technology, especially in Japan. One bright spot has been the wireless segment.” However, technology funds with a restructuring bent are raising money, notes Slawson.

VCs expect the outlook to improve especially as Japanese pension funds are poised to commit more to the alternative asset class. While pension funds in the past were legally restricted to investing mainly in domestic securities, their inability to meet their obligations has led the government to relax these restrictions and allow more pension money to go to alternative assets. Although this would still be a small percentage of a fund’s total allocation (less than 1%), the prospect of being able to tap into the world’s second largest pool of pension funds “will have massive repercussions,” says Slawson, “I would say not just for private equity but also public equity as well.” Japanese pension funds have already begun to tap the U.S. market (for example, Mitsubishi Capital Corp. co-sponsored a fund-of-funds with Pacific Corporate Group in 2000) and contributed about 10% of committed capital in 1999 according to the Venture Economics study (note: pension fund investments were made through trust bank accounts).

As gaiatsu impacts the venture scene, the Japanese seem determined to create a dynamic industry. In May of this year, the Minister of Economics, Trade and Industry, Takeo Hiranuma unveiled an ambitious plan to create 1,000 venture firms in three years despite the market downturn. While even the most optimistic of VCs express skepticism as to whether this will happen, it may be just a matter of time before a revitalized industry emerges.