The effects of Japan’s public markets surge are being felt in the private market

The Nikkei share index ended 2023 at 33,464, the second highest year-end price, only after the 38,195 it hit in December 1989, at the peak of the bubble economy. The surge in the index has continued, and it has surpassed 36,700 as of 8 February. Market analysts are predicting the index to reach a historic high and eclipse the 40,000-mark in 2024.

That isn’t all. In his new book, published in January, Hideto Fujino, the founder and CEO of Rheos Capital Works and the CIO of the popular mutual fund series “Hifumi Funds”, predicts the Nikkei average will reach 100,000 in the next decade.

When the Nikkei average more than doubled between 2012-2020, sceptics owed it to Bank of Japan’s unprecedented purchases of the exchange-traded funds, and raised questions around repercussions of unwinding the positions. Cynics, meanwhile, dubbed the post-2020 market hike the “Buffet Effect”, alluding to the herd mentality by investors who simply looked to follow Berkshire Hathaway’s shopping spree of Japanese stocks that led to momentum in 2020.

Indeed, economics common sense tells us that the stock market is benefiting greatly from inflation, resulting from Bank of Japan’s low interest rate policy. Harvard professor Kenneth Rogoff warns that the low interest rate, which sets the basis for inflation, could be a red flag for a country with a debt-to-GDP ratio of over 250%. For this reason, he marks out Japan as one of the four key themes to watch for in 2024.

If Bank of Japan adjusts the exchange rate to mitigate inflation, it would need a Maestro to subtly manage investors’ expectations in doing so. Failure to do so could result in a financial disaster, since global investors have weighed on the low yen level. This is a sober reminder that the Bank of Japan’s persistent low interest policy in the 1980s, inducing investors’ overoptimism, was at least partly responsible for the bubble economy, while the policy reversal to raise the interest rate led to the bubble’s bursting.

Policy initiatives and structural changes

There is more to the surge in the Nikkei, however. A significant government initiative of the current Fumio Kishida Administration is the Doubling Asset-based Income Plan announced in 2022. This policy provides a tax incentive for individuals investing in stocks. It is a conscious effort by the government to shift Japan’s JPY2,000 trillion-plus personal financial assets away from cash and deposits—which account for more than 50% of all assets—toward stocks and investment funds, which account for roughly one-third.

The brushing up of the Tokyo Stock Exchange’s Corporate Governance Code is another oft-quoted source of change. Originally set up in 2015, revisions in 2018 and 2021 under the Shinzo Abe Administration changed corporate governance practices for the better. For example, the latest update report from the TSE as of July 2022 shows the ratio of JPX Nikkei 400 companies with more than one-third of independent external board members has reached 95%, compared with 34% in 2018. The report also shows 92% of JPX Nikkei 400 companies have set up independent committees to appoint board members and determine their remuneration, versus 34% in 2018. These numbers mark sharp departures from classic Japanese corporate culture which saw board members promoted internally (or not) through a Kremlin-like power struggle.

The drop in the cross-shareholding ratio also illustrates changes in corporate governance. Cross-shareholding was used by many Japanese conglomerates to create corporate groups. The objective was to create strategic alliances, but the by-product was the creation of defensive fortresses against shareholder activism. But given criticism from independent shareholders, the cross-holding ratio has diminished rapidly to 31% in 2022, less than half of its peak in the 1990s.

Separately, life-time employment and seniority-based payment are also becoming a thing of the past. Jesper Koll, expert director of Monex, quotes a study that shows one in five University of Tokyo graduates quit their first jobs within the first five years. The younger generation, Koll points out, prefers merit-based, transparent compensation schemes to seniority-based, premeditated ones. Companies that are compensating employees on a result-driven basis are hiring more competitive employees.

Spillover effects on private equity

These factors that are energising the public market are having a major impact on the private equity industry in Japan.

The Japanese management buyout market in 2023 broke records, with total deal volume exceeding JPY1 trillion for the first time. Headline-grabbing public to private transactions such as Toshiba (led by Japan Industrial Partners), Benesse (led by EQT), and Taisho Pharmaceuticals (led by the management) boosting the private market.

Another factor that is plausibly resulting in companies’ willingness to delist is the persistent push for reform from activist funds. In many instances, companies prefer going private to being choked by activist funds and listing requirements that are only growing more stringent.

In the venture capital space, the government—in particular the current Kishida Administration—has been making noticeable efforts to boost investment activity and infrastructure. Coupled with the Doubling Asset-based Income Plan, the administration announced the Startup Development Five-year Plan in 2022. This plan aims to increase Japanese startup investment by 10 times and create 100 unicorns by 2028.

Kishida’s policy calls for fundamental changes in the mentality for entrepreneurship, such as through education. But there are more direct initiatives such as semi-public Japan Industrial Corporation’s startup investment programme, tax relief in angel investment, and J-Startup, which provides consulting services for startups.

The startup market in Japan has been growing in recent years, but still lags that of other developed markets. A 2002 Ministry of Economy, Trade, and Industry (METI) study reveals that startup investments in Japan were 33 times smaller than in the US, and also significantly lower than in the UK, Germany and France.

It was not until 2016 that Japan saw its first unicorn when the e-commerce startup Mercari exceeded $1 billion in valuation. Since then, the number has hovered at about 10 as some of them go on to be publicly listed or acquired by strategic buyers.

While it may be too early to expect immediate results from Kishida’s policy initiatives, they are sending a positive message to the market. Sweden-based EQT’s acquisition of startup HRBrain in November 2023 was a landmark investment that saw a buyout fund take the majority shares from VC funds. The said METI study shows that 24% of startup exits in Japan have been through M&As such as the EQT-HRBrain deal – this number stood at 67% in EU and 90% in the US as of 2020. For a long time, the Japanese IPO market was criticised for muscling VC-backed startups onto listed markets, only to benefit the IPO underwriters and see post-IPO prices drop rapidly. PayPal’s $2.7 billion acquisition of Japanese BNPL startup Paidy in 2021 was a watershed deal; the EQT-HRBrain deal may pave way for other startups to consider M&A exits to buyout funds.

About the author

Motoya Kitamura is the director of LUCA Japan, which he co-founded in 2021. He has been involved in private equity investment for more than 20 years as an investor in funds, buyout deals, start-up companies, and secondary deals. Other than investing, Motoya has also worked on business development, compliance and fundraising at private equity firms. He has also written several books in Japanese on private equity investment.