Small But Steady

Advantage Partners cofounder Richard Folsom talks with J@pan Inc's Sumie Kawakami about the buyout business in Japan.

WHO SAYS THERE AREN'T enough buyout deals in Japan? It may all be a matter of perspective. Richard Folsom says his firm, Advantage Partners, sees at least 150 opportunities a year. "Our view is that there is actually very steady growth in deal flow, both in terms of quantity and quality. And we are seeing that growth continue steadily," says Folsom, a cofounder and representing partner of the firm.

Because of the dramatic entry of big-name foreign funds in Japan after the Asian financial crisis in 1998, many investors expected an explosion of activity on the buyout front. "That hasn't happened," Folsom admits. "People who had expectations that hundreds and hundreds of deals would be coming out have been disappointed to a certain degree."

But Advantage Partners likes what it sees. The firm has so far closed 11 deals since it raised its first buyout fund -- the very first of its kind in Japan -- back in 1997. An average of two a year is a pretty good record, considering that there were only a couple of dozen buyout deals during the last year in Japan, and that some players have withdrawn from the scene without closing a single deal. What's even more unusual is that Advantage Partners has already exited three of its 11 deals.

A middle-market player
But Advantage Partners is no Ripplewood. Its deals are smaller, averaging somewhere between JPY3 billion and JPY10 billion (Ripplewood Holdings (US) paid over JPY100 billion for the former Long Term Credit Bank, now called Shinsei Bank). "We are not looking to do mega-deals," Folsom explains. "Equity from our fund in any given deal is between JPY1 billion and JPY4.5 billion."

Being an independent domestic firm, Advantage Partners doesn't have the same degree of access to global institutional investors as some of the mega-players. Its first fund, MBI I, was JPY3 billion; its second, MBI II, was JPY18 billion. The company is currently raising a third fund worth JPY50 billion, which is big compared with other domestic buyout funds, but still much smaller than those of the biggest players. Apart from the Shinsei deal, Ripplewood Japan raised JPY110 billion specifically for Japan and Cerberus raised JPY200 billion.

Advantage Partners isn't a distressed-assets player like Lonestar, which has bought troubled golf courses and resorts and made huge profits in the early years of Japan's buyout history. Nor is it looking at bankruptcies that loom on the horizon. Out of 11 deals that Advantage has closed, only one -- with Fuji Machinery Manufacturing and Electronics -- involved companies that actually filed for bankruptcy protection.

Instead, the core strategy of the firm has always been to focus on what it calls "the middle-market companies," with sales of several billion to several tens of billions of yen. "I think that middle-sized companies are relatively easy to grow profits from, either by growing sales or increasing cost-performance," Folsom says. "In terms of performance, it's the size that's easiest to work with. But the most important of all is the volume of deal flow. Yes, there will be some mega-deals sometimes, but not all the time. We want to do deals year in, year out."

Consulting background
Just recently, the firm bought 100 percent of Intuit Japan, a vendor of popular Japanese accounting software, from its US parent company for JPY95 billion. As featured in J@pan Inc's March issue, page 10, some say the bid was a bit too high for a company with JPY6 billion annual sales, but Intuit Japan CEO Kozo Hiramatsu says the decision to partner with Advantage Partners wasn't all about money. He says the firm looked at more than 10 candidates and decided Advantage Partners had the longest performance record. "It also has solid experience and a record of successful exits," Hiramatsu says. "Plus, many of its staff originally came from consulting firms."

It wasn't long ago that company owners felt that
being bought or even merging with another
entity was something to be ashamed of.

The two founders and representatives of Advantage Partners, Folsom and Taisuke Sasanuma, are former consultants at Boston-based management consulting firm Bain & Co. They worked mostly in the Japanese market, but they were also able to watch the activities of Bain Capital (the private-equity arm of Bain) in the US during the late 1980s. "That was where we got the initial ideas for private-equity investing as seen in the Bain Capital model," Folsom recalls. "To take consulting capability and to apply it into private-equity investing: Bain Capital has proven that that model works quite successfully. We thought this was something we would try to do in Japan."

In 1992, they formed Advantage Partners. But the time wasn't ripe for buyouts in Japan. Back then, there were a lot of restrictions and regulations, and the environment wasn't ready for the buyout funds they envisioned. In the company's first five years, it concentrated more on venture-capital investing.

Then came the Big Bang financial reforms in Japan at the end of 1996. One of the changes was a revision of the anti-trust law, which allowed a fund or a holding company to own the majority of a company and be on the board of directors. "Those were two very basic elements of our investment philosophy: for a fund to have a majority control, and to be able to have an active participation in management," Folsom recalls.

In 1997, Advantage Partners quickly moved to raise capital from institutional investors. It raised MBI Fund I from 10 Japanese institutional investors. Industry sources say the initial fund was considered to be indirectly controlled by Marubeni, a major trading house that provided a large portion of the JPY3 billion. When the firm raised MBI II in 2000, however, it began talking to some investors outside of Japan. Foreign investors became more familiar with buyout activities in Japan. Folsom says about 20 percent of the company's MBI II Fund is from non-Japanese investors. He expects 40 percent of the third fund, which Advantage is currently raising, to be non-Japanese capital.

The mission
Ironically, the negative image of foreign buyout funds so far has worked favorably for Advantage Partners, which is essentially labeled as Japanese even if Folsom is American. "There is a perception -- or misconception, whatever it is -- about foreign funds," Folsom says. "I see a clear preference on the part of many sellers to deal with domestic buyout networks."

Over the last few years, however, Japanese corporations have come to see positive economic value in buyout activities. In addition, management buyouts (MBOs) are becoming more acceptable for Japanese corporations whose parent companies are having financial trouble. Industry sources say that many companies would prefer to become "independent" in partnership with a private-equity fund than be bought by a big corporation.

"One of the drivers behind deal-flow increase is the willingness or acceptability of selling," says Folsom. Advantage Partners defines M&A as "freeing a specific company from various constraints of the existing shareholders or owners that keep the company from achieving its potential in terms of growth and profitability."

Folsom offers the example of Icreo to make his point. In 1999, Advantage Partners acquired this infant milk company from a US pharmaceutical firm, American Home Products, through an MBO. The company was in the red at the time, but Advantage Partners saw growth potential if the company could be set free from its parent. First of all, as a participant in the World Health Organization (WHO), American Home Products had various self-imposed restrictions. For example, the parent firm is required to respect the wishes of WHO to promote breast milk, particularly in Third World countries, and cannot advertise infant milk. That affected what the Japanese branch could do in terms of promoting infant milk. Another problem was the budget. "If it's non-core, you don't get a budget for new spending -- new projects, new training or hiring," Folsom says. "There are various constraints a company gets that basically curtail its growth." Due to changes in its sales structure as well as its investments, the company turned a profit a year after the MBO. Subsequently, the fund sold the company to Ezaki Glico for more than double what it paid, industry sources say.

An MBO by the former systems-integration division of Japan Metals and Chemicals in 2000 may turn out to be another example of Advantage's investment prowess. "The parent company had very tight financial situations in a very tight industry; this company eventually filed for bankruptcy a year after the sale," recalls Folsom. But systems integration at the time was a growth industry that required new people, training and incentives -- the very things the parent was curtailing. After acquiring 100 percent of the division, Advantage turned it into a company called AiCo, sent non-executive directors to the board and hired key management members.

The negative image of foreign buyout funds
has worked favorably for Advantage Partners,
which is essentially labeled as Japanese
even if Folsom is American.

The fund isn't only looking at MBO opportunities, however. In the case of Actus, the former Minebea furniture company, the fund sent in a new president, because the previous president was going to return to the parent company after the acquisition. Folsom says the decision to work with an existing management team (MBO) or bring in a new team (management buy-in, or MBI) depends on the circumstances in each case; but either way, the fund works closely with management teams.

"Buying it out from under that constraint, you allow the company to have strategic freedom to do the things it needs to do as an independent company," Folsom contends. It sounds great, but exiting these deals can be tough when weak capital markets make initial public offerings (IPOs) so difficult these days. All three of the deals Advantage has exited were done by sale to a third party.

Advantage Partners claims its return on investments so far has been 30 percent annually. But the fund is far from perfect. Fuji Machinery Manufacturing and Electronics was scheduled to go public last year, but its IPO was put on hold because of the sluggish IT market, the Japanese media says.

Despite severe competition, Japan's system is changing for the better as far as private-equity funds are concerned. Industry sources expect the scheduled establishment of the Industrial Revitalization Corp to help boost deal flow. However, Folsom feels the government can do better, especially in the field of taxation.

In April 2001, the accounting system was changed to prohibit a company from amortizing goodwill as a tax-deductible expense in M&As. Folsom says the change had "real negative impacts on LBO acquisitions." Industry sources say that some buyout funds are now asking the government to revise the system.

Whether what Folsom calls the Bain model -- the combination of consulting and financing -- will work in Japan is yet to be seen. But his firm has been in Japan longer than anyone else, and he is committed to staying here and making deals. @