KCS: The "Alternative" Investor

Back to Contents of Issue: April 2005

Akira Fujii launched an investment fund with a difference, one providing not only seed money but also loaning operating funds and giving cost control advice to inexperienced CEOs.

by John Dodd

Akira Fujii had been with Mitsui Bank for more than 28 years when one morning in 1995 he was told he and some other senior managers would be transferred to a subsidiary. The new position, he felt, would offer much of the same sort of work he had been doing at the bank and was a step down. He wanted a fresh challenge and decided to build his investment experience into a new career outside of banking altogether.

Thanks to an excellent track record as a cost-cutter, he was asked to help a struggling IT and consulting firm called KCS. The 30-year-old company had been steadily receiving consulting contracts from the government, but after a stock trading scandal at its parent organization, KCS had fallen on hard times and was in debt -- about JPY3bn, for sales of only JPY2bn.

Although dubious of the firm's chances of recovery, the challenge of trying to turn around the company appealed to Fujii, and he came on board as Senior Financial Manager. He soon learned that although the incumbent senior managers had lost their direction, there was nothing wrong with the quality of the junior and mid-level staff. Therefore, within weeks of joining, he decided that the only way to dig the company out of a hole would be to make a personal financial commitment to the business. Thus he became a guarantor and shareholder, and brought in new investors to alleviate the debt burden. Two years after joining KCS he was its CEO. He was able to turn the company back into sustained profit within five years.

Formation of a Strategy
In the course of fixing KCS's immediate problems, Fujii decided to redirect the business beyond body shopping and engage in more strategic activity. In particular, given his banking background and wide personal network, he got out of the office and hit the streets, visiting CEOs he'd met during his banking career. Slowly but surely he started bringing in not only more leads, but also requests for all kinds of upstream business restructuring.

Fujii needed every advantage he could get to turn the ailing business around. One of his most effective tools was (and remains) a discussion/study group he formed in 2000 called "Sansuikai." Group members were primarily solicitors, accountants, bankers, CEOs, and other corporate strategy-related professionals looking for a way to help Japan escape a 10-year recession. The topic matter was relevant, and the group grew to over 100 members. Business leads flowed Fujii's way.

Just before forming Sansuikai, Fujii did something else smart to complete the foundation for the fund management ecosystem he would later build: He became an ISO certification consultant. The new ISO consulting work gave him the chance to approach and work with many high-quality venture companies. Whenever he found a company that had excellent processes, quality control, and IP, but was struggling for profits, he noted it would be a good candidate to approach with an offer of investment funds later.

One outcome of the far-reaching discussions held by Sansuikai was its members' agreement that Japan's cautious banking sector was impeding economic rejuvenation by shying away from funding start-up companies. Thus such companies were forced to start businesses underfunded. As a result, when money did come in, there was a conflict over allocation of funds: Should they underwrite the original core business, or bolster the income-earning businesses? Consequently, these companies would soon be in trouble. From his banking experience Fujii knew the quickest way to kill off a promising company is to run out of cash at the end of the month.

To be sure, Japan does have a bank tasked with making loans to venture companies -- the Nippon Shinko Bank. The bank even has a JPY40bn venture fund. However, until the end of 2004, only JPY4bn of this fund had actually been loaned to target companies, owing to the bank's inability to look at future valuations versus past performance. As Fujii points out, most loans officers at such institutions are ex-employees of city banks, and only know how to value firms by traditional methods.

Fujii started to realize that this was both a challenge and an opportunity, and before long hatched a plan for a venture fund with a difference -- the fund would not only provide seed money but, after the business got started, also loan operating funds and provide cost control advice to help inexperienced CEOs continue to grow their businesses.

KCS Partnership Funds
One of the drivers of Fujii's interest in making loans versus simply providing equity seed financing is that after plowing through their first round of investment, most venture companies can't get operating cash or can only get it at exorbitant rates of interest. For example, while city banks charge just 2-3 percent interest per annum, they usually require recipients to have a similar value of collateral to "insure" the loan, something most small or medium-sized enterprises (SMEs) do not have. Then there are non-banks, which charge 15-18 percent, and, of course, sarakin (loan sharks), which charge the maximum rate of 30 percent. Fujii's company today lends money out at 10 percent, a rate that has brought him a long line of customers.

Also driving Fujii's decision to become a broker of equity and debt funding was his discovery he could leverage his business reputation to become a clean source of cash. Smaller publicly listed firms are especially concerned about the quality of the funding source. A dirty money scandal would severely damage a public firm's stock price. Therefore, KCS, well-known for its ISO work and due diligence consulting, has become a "clean" loan broker of choice in recent years.

In 2001, Fujii launched an investment and loan company, called KCS Partnership Funds, now operating as an independent unit based in Kojimachi, Tokyo. The fund has more than JPY2bn under management, and in the last two years has invested in or extended loans to 26 start-ups in fields ranging from biotechnology to a high school for children with emotional problems. Of the recipient companies, two are already on track for public listings this year or next.

Balancing Deal Size
Although Fujii's heart is in the turn-around of SME firms, he is also pragmatic, and knows that occasional larger deals provide not only bigger profits, but also the media coverage necessary for his self-help agenda. His first major deal was brokered by a Sansuikai member, giving both him and the target company management an existing foundation of credibility and trust, without which even the most advantageous buy-out will fail in Japan.

In July 2004, Fujii and KCS Partnership Funds helped the JASDAQ-listed company Nippon Furnace Kogyo Kaisha, Ltd. (NFK) raise JPY43bn in revitalization funds. Fujii's team was in charge of the entire rescue operation and was able to find the cash in just three months. NFK's problem was that it had had a particularly bad year in 2003, and suddenly, in spite of its sterling technology, its lead bank wanted to curb its overdraft privileges. Ironically, NFK's clients are all top-draw firms, including Toyota and Mitsui Bussan.

Based on the success of that financing project, Fujii has since been approached by other companies that wish to raise between JPY2bn and JPY5bn each. With this volume of new business in the pipeline, Fujii realizes that he must look beyond his usual investor community, and is now seeking new sources, in particular, foreign funds, which have been so successfully applied in Japanese buy-outs by MKS and Advantage Partners.

Staying Independent
Fujii knows what can happen to a small company that invites in a single major new shareholder -- who decides they want more than just an investment. The shareholder can bleed a company dry, leaving it a captive subsidiary -- to the disadvantage of other shareholders. Fujii decided early that if anyone was going to have the ultimate say in how a business should be run, that person would be him -- and he would follow a policy of spreading investment around, thus preventing over-influence by a single party. As a result, investors in his funds now focus on profits and not on other strategic issues. This policy doesn't just serve Fujii, it also allows the investee company's management to focus on doing an independent IPO.

Accordingly, KCS Partnership Funds now manages investment money from more than 10 wealthy individuals and companies, each with JPY200 -- 500m committed, including JPY1bn from KCS itself. Many of Fujii's early investors came through personal introductions; however, more recently his reputation is growing, and both wealthy individuals and companies are contacting him for investment opportunities. What's more, previous clients are returning. One such company is NFK, which after Fujii's successful fund raising for them, requested KCS to provide ISO consulting, and then concluded a consulting contract for start-up businesses it is funding.

In terms of debt financing, the most common requestors of non-bank-related funds in Japan these days are companies that have already done an IPO but require an extraordinary injection of funds for a one-time business venture. Take, for example, a development company that approached KCS via one of its shareholders. The company, already listed, needed a JPY3bn investment. KCS made a quick decision to assist and is now raising the funds. KCS is also handling deals involving water purification through biotechnology, a venture to provide eco-toilets for disaster areas, the rapid expansion of unique bakeries in regional towns and cities, a new nursing care business (condominium with attached health/nursing care facilities), an eco-business drama by a young director, a game-software publishing firm, a recycling and waste-disposal firm, and various construction firms with contracts already in hand.

In addition, KCS is now in the midst of a project with a major transportation company with aerospace interests. KCS Partnership Funds began planning two years ago an agreement to purchase shares from its majority owners for JPY5bn. Although the company possesses superlative aerosurvey technology, it has been unable to secure a leading position in the industry. First of all, Fujii himself took over the management, and now he is recapitalizing the company. He is confident that if he introduces new US surveying technology to supplement existing lines, he can boost the share price by 300 or 400 percent in two years.

More Than Just Pin (ball) Money
But possibly the largest piece of business before Fujii involves Japan's biggest business sector, a JPY3trn industry that almost no one talks about -- pachinko (Japanese-style pinball) parlors. There are 17,000 pachinko establishments in Japan, many of which are operated by people with less-than-savory business backgrounds. Pachinko parlors are unregulated and cause numerous headaches for their approximately 2,000 industry suppliers -- meaning that interest in investment is very low.

But it was only a matter of time before someone sought to tame the Wild West of Japanese entertainment. As we saw in 2003 with the setting up of the first love hotel funds in Japan, it is possible to bring a degree of trust to such underground industries. Thus Fujii took it upon himself to burnish the pachinko industry's reputation.

The pachinko industry is a pyramid. At the top are the pachinko machine manufacturers, who effectively own the patent rights to the machines. Next are the equipment and service wholesalers, who wind up financing the pachinko operators and placating the manufacturers. At the bottom are the parlor operators. They generate cash but are poor at managing money.

Fujii plans to help normalize the industry so it will attract investment. First, he is implementing an ISO 9001 and ISO14001 program, which allows operators to declare that they are running their establishments as proper businesses. He introduced the first ISO trial in the middle of 2003, and already has companies signed up and preparing for their ISO inspections. Second, Fujii plans to provide funding for those operators and their suppliers who are in the black month-to-month, but who need additional funds to refurbish their premises or otherwise improve their businesses.

The special challenge for pachinko parlor operators and their suppliers is to raise funds, and, of course, the nub of the opportunity for Fujii is that even those operators running significant profits and keeping transparent accounts are considered by the authorities to be running businesses "injurious to public morals," for which reason they are not allowed to go public in Japan. In other words, pachinko operators and their vendors have little access to capital markets, and therefore the only other sources of cash and credit are small amounts of bank debt, non-bank sources, and tegata (promissory notes).

Two years ago there were just two banks willing to lend money to operators on a major scale, and today, after the collapse of the Chosen and Ashikaga banks, there are none. As for the non-bank side of things, Orix is the major player, doing about JPY70bn of business with pachinko firms and their suppliers every year. But the rates are exorbitant, and the risks of lending money are high.

That leaves this multibillion-dollar industry with tegata as its major form of credit and funding. Japan's promissory note system functions as a kind of check-issuance system for some companies. The promissory note is a promise by the issuing company, the pachinko operator, that it will pay the supplier (the wholesaler) the amount covered by the note, usually within 60 to 180 days. Because of the long repayment cycle, essentially credit for the issuer, such promissory notes are often redeemed by suppliers ahead of the payment period, at a discount at a local bank. The redeemability of the note and the size of the discount applied by the bank depend upon the issuer's size, profitability, and reputation. For large companies the discount rate may only be 3-5 percent. However, for smaller, less stable companies, the rate could be as high as 25 percent.

The issuance of tegata in the pachinko industry is a huge business, with about JPY3trn ($30bn) of promissory notes in circulation at any particular time. Fujii reckons that over 50 percent of these are not discountable, owing to the issuers' small size -- rather than because of financial performance problems. His plan is to act as a clearinghouse for tegata in the pachinko industry, taking a small commission for each transaction.

While most people would think that funding a semi-underground industry such as pachinko parlors is fraught with risk, Fujii has been able to work out a system which makes it considerably safer. He has teamed up with AIG, an American insurance company, to underwrite 90 percent of the loans extended, up to JPY100m per company and up to a total loans portfolio value of JPY100bn. Fujii then covers the missing 10 percent by requiring intending lenders to place an equivalent amount on deposit. In this way, he assumes no risk on the principal, and reduces his exposure to the simple costs and inconvenience of trying to recover unpaid loans to the satisfaction of the insurance company

The fund's operating procedure is simple. The KCS Partnership Funds entity attracts private and corporate investors, who provide the original capital. The actual business operations and liabilities are then carried by P&D, a surety company affiliated with KCS Partnership Funds. And the American insurance company underwrites the risk. P&D makes a commission of 2.5% on each lending transaction, which it shares with KCS Partnership Funds. The insurance firm gets monthly service fees, a fixed cost inside P&D.

Just how did Fujii get the American insurance company to offer 90 percent coverage for loans to pachinko parlors and their suppliers given the nature of the industry? As Fujii notes, his insurance partner is an expert in risk analysis, and it has found that the bankruptcy rate of pachinko parlors is only 1.3 percent. So the partner sees it as a risk worth taking. P&D allows 18 months for clearing two-to-six-month notes issued by companies in the pachinko industry. For each client it earns a commission of 2.5 percent and receives a deposit equivalent to 10 percent of a note's value.

The basic numbers mean that P&D and KCS Partnership Funds can together expect to receive up to JPY2.5M transaction profit per client in a 60- to-180-day period. Multiply this by hundreds of companies a year, and the returns look good indeed.

Such a system is revolutionary in the pachinko industry. When Fujii disclosed the system in March 2004, the response was overwhelming. In just one month after the press conference, KC Partnership Funds and P&D together received more than 700 requests for funding from pachinko parlors and suppliers -- with a total combined worth of more than JPY70bn ($700m). When the news hit the wires and the user feedback peaked, Fujii was still finalizing funds from third-party investors, but after seeing the quality and volume of the responses, he decided to waste no further time, and arranged for a tranche of capital via KCS Partnership Funds. Such trading on your own account is not for the faint-hearted, but for future investors, both Japanese and foreign, it is great proof of Fujii's willingness to put his money where his mouth is.

Companies receiving funds undergo an evaluation that not only looks at financial performance, but also the quality of their management and shareholders. (Fujii is eager to avoid doing business with the yakuza.) The case book for each loan/investment request then goes before a formal investment committee, thereby ensuring the accomplishment of proper due diligence.

Ikkisei Gakuen
Fujii generally finds his investee targets through his ISO consulting. Once Japanese executives get to know him, they ask his help with other issues as well. For example, he was asked to help with funding for Ikkisei Gakuen High School, established for truant students. The 200-student, 10-branch school originally had sought ISO certification to allay parental fears about its stability. After Fujii started working with Ikkisei, he found that they had a number of structural accounting and finance problems. He made recommendations, and eventually the school board asked Fujii to come in, invest, and eventually take over the daily operations.

To date, KCS has invested JPY1bn in Ikkisei, and Fujii has appointed some senior managers to put the operation on a proper business footing. In just two years, he has eliminated about JPY1.2bn of bad debt, and he foresees the school becoming profitable in 2006, thereafter being ready for either a trade sale or IPO. That's assuming, of course, that Fujii doesn't decide to use Ikkisei as a vehicle for takeovers of other schools -- something he is mulling over.

In the end, the decision to buy or sell Ikkisei will be his investment committee's, but since the school fills a pressing need for alternative education in today's pressure-cooker society, Fujii thinks that the committee and the investors it represents will desire the organization become a larger piece of the KCS business. Fujii thinks they should use the school as a model for alternative education organizations in Japan.

Fujii has a right to be proud of his turnaround of Ikkisei. Prior to his involvement, the school had tried to get loans from various banks, but due to the nature of their student base -- all students have troubled backgrounds -- they were usually turned down. In desperation the previous owner borrowed money from children's parents and even moneylenders, getting him dangerously in debt as a result. Fujii jumped in and restructured the financing, making sure that the school's existence could no longer be threatened by a single creditor.

After sorting out the loans and debts, Fujii focused on increasing revenues and the utilization ratio of the school facilities. Thus he has been concentrating on open-learning students, who come to the school twice a week. Fujii reckons that a 20 percent increase in the number of students will bring the school into sustained profit. To that end he has instructed Ikkisei's teachers to visit local public schools and ask teachers if there are students who might benefit from an alternative education program.

The Foreign Connection
Fujii believes that foreign institutional investors are pragmatic and is eager to open up his deal flow to them. He points out that while the pachinko business has a poor reputation, so did the Japanese real estate and credit card industries. And yet, foreign banks and LLPs have entered the market and done extremely well with their investments. As for the negative elements of those industries, the foreign firms have dealt with them within the law.

It remains to be seen whether Fujii can avoid the low end of the pachinko market through the placement of a hurdle for aspiring loan recipients to overcome -- an ISO rating. If he is successful, he will have a variety of motivated customers with great cash flow and accountable finances. Investment backers who can deal with the negative image of the pachinko industry stand to make excellent returns working with Fujii. And competitors such as Orix will either have to compete by making interest rates more reasonable and systemizing their business dealings, or watch Fujii run away with potentially massive market share. @

KSC Co., Ltd.
Koishikawa IS Bldg., 2-6, Kohinata 4-chomeBunkyo-ku, Tokyo 112-0006
Phone: +81-3-5842-3601
Fax: +81-3-5842-3605
http://www.kcsweb.co.jp (Japanese language site)
Email: tagawa@kcsweb.co.jp

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