VC Money

Back to Contents of Issue: August 2000

by Daniel Scuka

If you want to fix a precise moment and place for the end of last year's venture capital boom in Japan, you may as well select midnight on February 2, 2000, and Tokyo's foreigner-friendly Roppongi nightlife district. That evening, Club Velfarre was host to what has proven to be the final Bit Valley Association entrepreneurial networking extravaganza. Packed in elbow to elbow, and with lights blazing and speakers' images projected three times larger than life on a huge digital screen, would-be dot-com founders eagerly lined up to swap meishi with their Net biz heroes, including Masayoshi Son, founder of Softbank, Tomoko Nanba, CEO of DeNA (owner of online-auction site Bidders), Hiroshi Mikitani of Rakuten Ichiba, Monex CEO Oki Matsumoto, Nasdaq Japan president Tatsuyuki Saeki, and folks from FreeML, Yahoo Japan, and Digital Hollywood, among many others.

And then there were the money guys, the venture capitalists, flitting about the shadows and sniffing for The Next Big Deal. The Asia Private Equity Review has reported that private equity investment funds in Japan climbed to at least $25.5 billion for 1999 -- and these were the guys holding the purse strings. Make no doubt about it: without their presence, their intimation of foreign riches, their aura of wealth and power, the wannabe entrepreneurs wouldn't have been half so excited. In the Internet game of new bit business and ultimate disintermediation, the VCs are the foxes amongst the entrepreneur chickens, and without them, most would-be dot-coms would be DOA.

But there's no doubt that last year's venture capital boom did end soon after Son addressed the masses at Velfarre. In March and April, the markets hit a series of bumps which added up, many said, to the long-expected correction. In April, Hikari Tsushin, parent company of Japan's wunderkid of the VC world, Hikari Tsushin Capital, saw its stock price drop through the floor. Hikari Tsushin Capital itself was hit with large-scale management defections, dragging the parent company's stocks even lower, and a lot of IPOs were put on hold.

Yet the end of the Velfarre high-tech bacchanals hasn't meant that the entrepreneurs and VCs have all gone home. Quite the opposite:

The second half of 2000 is seeing a renewed Japan VC boom take off.But this time, there's little show or glitz, and the VCs are smarter, slyer, and, like Machiavelli's proverbial foxes who are pros at recognizing traps, won't easily be hoodwinked by business plans full of holes. And they've been joined by a bestiary of like-minded money types: investment funds, angels, incubators, catalysts, habitats, and other sources of private equity funding, all zeroing in on the hottest news on the world's Net scene: technology ventures in Japan.

How much venture money is really out there this year? It's tough to say. Our own thumbnail survey shows some ¥150 billion in private equity targeted at Japan for 2000, the majority, it's safe to assume, being funneled to technology investment.

But long-time industry watchers here warn that not all funds announced for a particular region or target industry actually get invested. "You've got to be careful," says Michael Korver, partner at boutique VC Global Venture Capital and author of a recent Japanese-language book on private equity. "Newspapers are often wrong, and people announce stuff that they have no intention of doing -- especially the big-ticket investment banks. They've been making announcements of hundred-million-dollar Japanese private equity funds, and you talk to them and they'll admit, 'Well, we did that because our competitor made an announcement, so we had to do something.'"

Still, there's room for some educated guestimation.

"If you add it all up," muses Whitney&Co. Tokyo pointman Paul Slawson, "There's probably a billion dollars that's come in over the last 12 months. And I'd say there's probably another billion on its way."

Bruno Grandsard from Japan Internet Ventures offers: "I would estimate that $2 to $3 billion has entered the market, but that only one-quarter of that has been invested."

It's certainly been difficult to open a newspaper this spring without seeing some new announcement of a major private equity fund heading to these shores, and high tech is the central theme that ties them together.

One of the early signs of a post-correction rebirth came predictably from hometown player Softbank, which announced on May 29 that its financial unit, Softbank Finance Corp., would go public later in 2000 in an effort to become Japan's largest investor in the online financial sector.

In May, Soros Fund Management announced an Asian investment drive, and moved to reopen its Tokyo office. Takeshi Fujimakai, managing director at JP Morgan, was named to provide investment advice for the fund's Japan efforts, set to account for the lion's share of the $1.2 billion in new investment.

Likewise, Credit Suisse Asset Management grabbed headlines in May with its announcement of a new Japan-based open-ended investment company. The balance of the new fund is to be invested in electronics, telecom, software, and securities.

As of mid-June, Hikari Tsushin's future remained uncertain, although the firm did book a ¥12.6 billion capital gain from sale of stocks in, and the unfounded rumors of pending bankruptcy had largely subsided. The parent firm still controls investments worth some $952 million against short-term debt of $290 million, and as of June 2, Hikari's 52-week stock performance was still up a solid 314 percent.

Morgan Stanley Dean Witter is one of the heavyweights keeping an eye on this country, and although details weren't available at press time, industry sources have confirmed that MSDW will be allocating a significant portion of its $3 billion-plus in available funds to private equity investing in Japan.

And of course, other big names are continuing their activities in Japan, including the Oracle, Sun, and Intel tech funds, and the investment houses Warburg Pincus, Patricof & Co. (Apax Globis), and Goldman Sachs, among others.

"Japan looks like boomtown even with the recent slide in the Nasdaq and Japanese stock market," says Keio University professor Bob Tobin.

Watching the big players, though, doesn't give a true sense of what's happening in the trenches of Japan's VC scene. The big players are, well, too big. As one senior manager at a large VC fund here explained, "The big money can't get into detailed investing. The best it can do is pick a country -- or currency -- and a sector, for example: 'USA' and 'anything Nasdaq.'"

To find out what's really going on, you've got to look at the smaller VC players, the smart money that can target precise amounts into specific, carefully vetted ventures. You've got to look at the VCs on the ground, and in doing that you've got to look at both the Japanese and foreign ones -- which is where things start to get interesting ...

OF THE MANY AXES against which you can plot Japan's ever-growing VC industry, the Japanese vs. the foreigners one is probably the most interesting. Tracking the differences and citing the contrasts is an endlessly complex study in culture, investment style, perceived worth of ventures across markets and technologies, Net savvy, international smarts, and emotional quotient.

"Many of the Japanese VC companies can't really assess risk and they don't know how to deal with it," says David Russell, senior partner at Japan Consulting Group. "So they use the syndicate system: 'Let's get 15 partners to share this risk with us, and if things go sour we won't look so bad.' That's not real venture capital."

Global Venture Captial's Korver points out that Japan has had a venture capital industry for some 20 years, but it has been very different from "private equity" as understood outside of Japan. "It's really been an effort by Japanese financial institutions to create relationships with companies to give them business in the future."

Perhaps the best way to understand Japanese VCs is to study one up close. NIF Ventures Co., for example, is one of the largest and best known. Formed in 1982 and comprised of offices in Japan, the US, and Asia, NIF has some ¥110 billion under management. Senior representatives provided detailed explanations on how the firm operates on the condition of anonymity.

NIF's nine-step venture assessment process includes technology due-diligence, performed in concert with an engineering team hired from outside, and financial due-diligence achieved through a full public company-standard audit. As for human capital due diligence, NIF's president will meet with and assess most of the venture owners, especially for significant investments (in excess of ¥100 million). NIF board members also participate in this process.

In addition to its direct equity investment business, the firm also offers a full range of consulting, management, HR, and other assistance to investee companies. "Nowadays, venture funds here are interested in all kinds of investment, including tech ventures and managed buyouts," says one company representative. "For their part, the large banks have a problem -- they need to foster young growth companies. So they're interested in setting up venture funds also. Some VCs are tying up with the smaller regional banks, and local governments and universities."

VCs like NIF and JAFCO have been following this spring's market slide extremely closely, but so far their business has not been greatly affected by it. This is perhaps incredible, but remember the Japanese VC's abhorrence of risk -- you don't lose sleep if nothing's at stake. Another effect has been to bring down valuation prices to more realistic levels, and from that point of view, NIF, like many, was "happy" to see the correction.

A company director also explained what he sees as the differences between the old blue bloods like NIF and the new players. Essentially, venture investment in Japan has traditionally meant providing a capital infusion -- and not much else. Whether the Japanese VCs can be criticized on this point is moot; it's simply one of the defining characteristics of the industry here. It does mean, however, that tremendous opportunities exist for VCs who can provide Silicon Valley-style incubation, hands-on management, and other direct, day-to-day assistance, which is precisely what some of the "newcomers" -- foreign and domestic -- are doing. "Some competitors take a partnership approach. Strategically, they try to get more from their investees," explains the director. "We try to offer our best advice, when necessary."

The final point to consider with the Japanese VCs is how they view a founder's track record, and the truth seems to differ significantly from conventional wisdom. Many here have decried the alleged Japanese cultural trait of never forgiving a failure. While it's true that a previous failure can be a damning barrier, there's no lack of support for students, for example, who retake difficult university entrance exams -- often many times. Likewise with entrepreneurs, there is an innate tolerance for honest failure -- it just depends on how the failure came about (yarikata). If a business fails, and the founder has caused significant unredeemed damage to customers, neighbors, partners, or creditors, there will certainly be social pressure against restarting -- and no VC would swim against that tide by providing new financing. But if the fall is a graceful one, there's no reason why a bloodied but wiser Netpreneur can't try again.

If NIF comes across as a little staid, then it may be helpful to remember that Japanese culture in general has not generally encouraged risk taking, financial or otherwise.

Nonetheless, it is possible to be too cautious with venture investment, and although some Japanese VCs like NIF have seen funds and IPOs growing steadily, the industry as a whole can be criticized on gross return on investment. In September 1998, MITI released a study assessing the performance of VC funds that had been managed by Japanese companies (including companies that invested outside of Japan as well). The average return of the 135-odd funds that MITI reviewed was down around 5 percent per annum, tracked back to the early 1980s. In fact, the 5 percent return that MITI found probably overstated the true performance as it included realized gains as well as portfolio value.

But change is happening at NIF and places like it, and if the style of investing remains much the same, then at least the target companies are becoming more startup-like. Since 1994 the profile of a typical NIF investee has shifted toward something more familiar to the San Jose crowd. Some 50 percent now have annual sales of less than ¥1 billion, and 48 percent are less than five years old.

The director says 20 to 30 percent of NIF investees go on to IPO success, some 10 percent fail outright, and the remainder are "the living dead" -- stable, but having no growth potential. "That's when we look at encouraging mergers," he adds.

Although there are strong cultural factors inhibiting those who would sell their company, managed and leveraged buyout activity is slowly starting to increase. The shacho syndrome happens because the position of president (shacho), with a chauffeured car, private office, and spacious home in a tony suburb, carries enormous prestige. Japanese society traditionally sees the proper role of a company founder as continuing with the firm, which often carries the founder's family name, until retirement -- and that not until a ripe old age -- or death. It's not uncommon for a founder to pass along control of the family business to a favored son; allowing an outsider to take control would be anathema. Likewise, when a business goes sour, as huge numbers have in the past decade of economic stagnation, many founders consider it quite acceptable to take their own lives in the hopes that insurance money will cover debts and outstanding payroll obligations.

Seen against this cultural background, the intense opposition to founders selling their companies, even when doing so would be manifestly good for all concerned, is quite understandable. Nonetheless, MBO deals have taken place this year, and more are on the way.

Brian P. Riordan, director of Broadview's Tokyo office, says the investment bank specializing in M&A is finding fertile ground here for buying and selling ventures. Riordan spends a lot of time evangelizing the virtues of the MBO, and describes the exit strategy as "a generally much less painful process" than going IPO. "Both valuation and price actually paid turn out pretty well in an MBO. Often times, a strategic purchaser can pay more than the markets are willing to offer."

Riordan is quite realistic when it comes to dealing with the cultural opposition, and he admits there are challenges. "Finding a willing seller is tough -- mostly for psychological reasons." And it's not just the founder's loss of status that is important. If the venture has grown and features a large workforce, and it's a cross-border buy, staff at all levels will be suspicious. "But there are ways to make people feel better about that," says Riordan.

In addition to reluctance to sell, Broadview has experienced some ups and downs here due to corporate-culture peculiarities. Japan's penchant for lower-to-higher consensus prior to making major decisions is one factor. "We've had deals where we were able to convince top management the deal made sense, that it was absolutely the best thing for all concerned. And management committed, but there was too much resistance from below, and the deal caved in," says Riordan.

Which is why incubation may be the right path for investing in Japanese ventures. Many feel that incubators are needed more so here then in the US, and the traditionally group-oriented nature of Japanese society would tend to support that view. It's also argued that fewer individuals here have the independent drive to build a business from the ground up. While that's patently untrue, incubators should play a key role in this year's venture scene simply because Japanese business as a whole has some catching up to do. Also, most Japanese get a genuine kick out of doing things properly, and if there's a convenient teacher around to share experience, few would hesitate to take advantage of the boost.

What's the difference between an incubator and a VC? It comes down to valued-added services. A pure VC, traditionally, offers money and little else, while an incubator offers money and everything else -- management, guidance, strategic partnerships, hand-holding, and even, states one VC, "help to recognize the venture's weaknesses."

Another qualitative difference lies in the number of investments and the size of individual investment, and these are related to the degree of managerial attention that can be given to any one venture. In short, incubators place bigger bets on a smaller number of companies, whereas VCs -- which range in size from individuals up to well-funded venture companies and the large banking and technology funds -- may invest in hundreds of companies, and can rarely offer more than periodic advice.

Of course, the new-style VCs, like Softbank, are putting a lot of thought behind their investing to ensure that investees are strategically related. The thinking goes: why not invest in like-minded ventures, where one can serve as customer to the other and help guarantee cash flow? Softbank's Jonathan Epstein, director of strategic planning, says: "An incubator is going to focus on a smaller number of projects -- typically fewer than five. A VC company invests in hundreds of companies, but it can't offer day-to-day, drive-the-business type of management."

It can be expected that tension will inevitably arise between incubators and their fledglings. "If you take X's money, you've got to do things X's way," one CMO at a startup being fledged by a large incubator here gripes. Another partner in a new venture cautions that incubation is one way to lose effective, if not actual, control of your company: "You get these awful [IPO] floatations out there, and there's another effect. You get these incubators saying, 'We're going to launch six companies.' Well, watch out: if you as a founder have no control over when your company goes public, you can get dragged right down with a lot of other poorly performing IPOs."

What are the key issues facing Japan's venture capital industry in the second half of 2000? The quirk about the venture scene here is there are many factors beyond the control of VCs and entrepreneurs that affect how the money guys invest and how entrepreneurs build companies. These include equity market rules, liquidity, investor confidence, the media, and Japan's economy overall.

Liquidity is perhaps the biggest potential wet blanket, and it's tied right to the heart of what has kept the small-time investor out of Japan's markets for so many years. The minimum share value here is ¥50,000, and brokers prefer big lot buys; meanwhile, intercompany stock cross-holdings, which are virtually guaranteed to never come up for sale, continue, and companies still issue too few shares. The result? Japan's markets have long been constipated, and the little guy has always been shut out.

Mothers, although supposedly a venture-friendly market, is suffering from some of these familiar problems.

There's also fear that a few bad IPOs could spoil it for all, setting the whole venture community back several years in the process. At one point in April, all of the seven stocks that had then done an IPO on Mothers were trading below their IPO price -- some below half the offering value. By June, only 12 companies had gone for a Mothers IPO, reflecting caution on the part of potential issuers, underwriters, and investors. None were recording profits.

In contrast, all of the companies that were scheduled for a June launch on Nasdaq Japan were recording pretax profits, and that, combined with the more stringent listing requirements, offers a ray of hope for the rest of 2000. John Desaix, senior VP and chief market strategic planning officer at Nasdaq Japan Inc., the seed organization behind the June launch of Nasdaq Japan, says, "a single bad IPO could kill the market for everyone -- we want to make sure that investors don't get burned."

Many here say that no real Silicon Valley-style venture boom is possible until the retail investor can get in on transparent, small-lot, venture stock trading. Softbank's Epstein says, "Will we see the stereotypical housewife and small-time investor moving the contents of her postal savings account down to her favorite broker? Absolutely. At least for the Nasdaq cross-listed companies, people are going to be able buy them in Japan in yen very easily, and that will be an incredible psychological change from today's climate."

Corporate governance is also a major issue facing the VC industry here -- especially where it affects reporting, transparency, and shareholder confidence. "Is there anything sound about Japan's accounting system? No," said Mitsuhiro Fukao of the Keio Business School recently in a speech. He was addressing the issue of accounting clarity and concluded that there's been a significant loss of confidence.

But perhaps the single biggest issue affecting investor and entrepreneur alike remains that of exit strategy. IPO remains the king, and as long as a mature MBO market fails to develop, Japan's venture economy will stay stunted. "Japan needs fundamental restructuring," says Michael Korver at Global Venture Capital. "The efforts of the large corporations to control and dictate whatever happens here has to change."

In short, Japan's still not ready for prime time. There's no doubt that everyone -- investor, entrepreneur, incubator, and angel -- is working to get there, but it's going to take some time. Building a Net-based venture industry in the US and other countries didn't happen overnight. But there's also no doubt that Japan's direction is right.

On the plus side of all this, because Japan's VC scene is still small and the market is immature, many of the big fund personalities are on a first-name basis with the smaller boutique VC operations. "In the US, it used to be clubby like this, but the VCs have all gotten more aggressive, and that's over," says one senior manager at a large VC fund here. "In Japan, the VC industry is not institutionalized. VCs share tips -- we all need info. At this point, there's no gating for quality -- anyone with an idea gets a hearing."

If nothing else, the people who help build the venture industry this year and next will be perfectly positioned to profit when the markets here do take off -- and we're betting they will.

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