• Government policy is drawing more private equity capital into technology
• Opportunities exist around, rather than in, areas like semiconductor
• Digital transformation is essential, yet paths to monetisation can be unclear
• Early-stage investors are leveraging Japan’s innate deep-tech advantages

In mid-2022, Japan unveiled plans to pursue a “new form of capitalism” by creating virtuous cycles of growth and distribution. The government clearly saw technology as its means to this end, flagging priorities from meat-and-potatoes business digitalisation to artificial intelligence (AI), clean energy, quantum computing, biotech, and space-tech.

Fast forward to April of this year, and Prime Minister Fumio Kishida is touring the US to round up investment dollars and convince incumbent tech giants to help implement the agenda. It coincides with Tokyo topping up JPY 920bn (USD 5.9bn) in subsidies for Rapidus, a newly established Japanese semiconductor manufacturer tied up with IBM.

“There will surely be more such opportunities for collaboration between Japan and the United States,” Kishida told American CEOs at a lunch event.

There is a distinct geopolitical flavour to proceedings, with security-sensitive technologies like chips often taking centre stage. But the more pervasive backdrop is arguably Japan’s decades-long low interest rate trajectory, its shrinking workforce, and related imperatives to stimulate new channels of growth.

It appears likely that the policy push – which also includes a five-year plan to build out the start-up ecosystem – will see technology-related deals account for an even greater slice of private equity investment in Japan. Indeed, there is already reason to think of technology as underpinning the country’s status as a relative investment hotspot in Asia post-pandemic.

Annual average investment in Japanese IT companies, for example, was USD 685.6m for the five years to 2020, according to AVCJ Research. Since then, the sector has attracted USD 1.8bn a year. By contrast, pure consumer investments reached an all-time high of USD 1.5bn in 2019 and hit an 11-year low in 2023 at USD 59.5m.

Many of the drivers are longstanding investor talking points, perhaps especially the urgency around digital transformation in the broader business sector and the need for innovative solutions for demographic challenges. So, does the new policy environment really change the landscape for private equity?

“The difference is there is a lot of incremental money going into a couple of specific themes. Your job is to figure out who is benefiting differentially from those themes,” said Jim Verbeeten, a partner at Bain & Company.

“There’s an additional dimension to identifying an effective company because you know there is a significant amount of capital that’s going to benefit some companies more than others.”

Into the value chain

Green-tech and data centres are among the themes set for a capital influx, both in terms of government investment and global operators setting up shop in Japan. Since the start of the year, Microsoft, Amazon, Google, and Oracle have committed a combined USD 27bn to AI and cloud computing-related data centres in the country.

There will be few opportunities for direct private equity investments in data centres, but the buildouts by strategic players are expected to deliver adjacent inroads from routers and cables to environmental management systems.

Indirect opportunities in this vein are more pronounced in the semiconductors space, where middle-market private equity investment is spiking from a minuscule base.

From 2014 to 2021, there were fewer than three private equity investments a year on average in Japan’s semiconductors space, with annual deployment of USD 6.6m, according to AVCJ Research. That jumped to 11 deals worth at least USD 160m in 2022 and 11 totalling USD 315m in 2023.

These figures exclude a Bain Capital-led consortium acquiring flash memory business Kioxia from Toshiba for about USD 14.7bn in 2017 and government-controlled Japan Investment Corporation (JIC) buying Shinko Electric Industries for USD 2.7bn in 2023.

The Carlyle Group has been active in the back end of Japan’s semiconductor value chain since at least 2007, when it invested USD 12.5m in chip assembly and testing company Nakaya. The private equity firm expects to do more in the near term.

“We’re starting to think of the semiconductor market more broadly as an area of increasing investment opportunity, particularly as AI is creating a new demand in the market,” said Jumpei Ogura, head of Carlyle Japan’s technology, media, and telecom (TMT) team.

“But we’ll be selective because some phases of company development need significant capex that is not best suited to the private equity model.”

JIC has been the biggest mover in this space. Notably, its acquisition of Shinko was an auction process that was said to include Bain Capital, Apollo Global Management, and KKR. As recently as April, it acquired chip equipment maker JSR Corporation via a USD 6bn tender offer.

Ogura sees government participation in semiconductors as a short-term competition factor for private equity but more significantly as a long-term positive in terms of driving M&A through non-core divestments and generally increasing liquidity in the sector. This thinking appears to be resonating with smaller PE firms as well.

“There are many specialised mid-cap companies and divisions of conglomerates [in the semiconductor industry] which may be investment opportunities,” said Makiko Hayase, a partner at Integral Corporation, which writes cheques of JPY 3bn-JPY 10bn (USD 18m-USD 64m) for companies with JPY 10bn-JPY 30bn in enterprise value.

“We believe that PE firms can help [those mid-cap companies’] growth strategies by supporting the capital expenditure and partner and integrating ancillary companies.”

Innovation agenda

Importantly, deal flow spurred by conglomerates not only plays into private equity strategies targeting de-risked technologies, it is also symptomatic of a widespread industrial push toward innovation and still emerging digital domains.

Hitachi is the poster child for this trend, having pledged to offload hundreds of subsidiaries in recent years. These sales have included businesses in transportation, construction, and advanced metals. And the proceeds went, at least in part, into IT assets such as GlobalLogic, which was acquired from Partners Group and Canada Pension Plan Investment Board (CPPIB) for USD 8.5bn in 2021.

Asked which tech verticals would be the most interesting in the foreseeable future, Yuji Sugimoto, a technology-focused partner and co-head of Bain Capital’s Asia private equity practice, pointed to four broad areas of interest: general industrial, TMT, healthcare, and consumer and retail. “All of these are intertwined with technology advancement,” he said.

To this point, private equity will probably continue to find most of its tech-related opportunities in the trends that predate the current policy push, including governance reforms to improve corporate productivity across multiple sectors. But there is a sense that the clarification of an official vision for a more digital economy is heaping pressure on investors to up their tech game.

“We’ve been more attuned to how GPs are able to support companies in various digitalisation initiatives, particularly in the context of some of the challenges in the greying workforce and shortage of labour in some sectors,” said Brian Lim, a partner at fund-of-funds Pantheon.

“That aspect has become more prominent of late, and we think that’s going to be a core skillset that’s going to differentiate GPs going forward.”

Investing directly in IT and B2B software-as-a-service (SaaS) providers is a discrete aspect of the digital transformation thesis. Enterprise IT is cash-generative and stands to benefit significantly from Japan’s behind-trend digitalisation.

Most of the companies in this space locally are known as system integrators, or “SIers,” and are essentially enterprise resource planning (ERP) specialists. This segment is described as fragmented and led by ageing founders, which should further drive deal flow.

Partners Group is concerned, however, that SIers could be undersized and insufficiently diversified in their offering, making them vulnerable to being usurped by the more sophisticated global players now accessing Japan’s digital transformation opportunity.

The private equity firm, which generated a roughly 5x return on the sale of its stake in GlobalLogic to Hitachi, is yet to make its first pure PE investment in Japan. It hopes to identify smaller versions of GlobalLogic in the local ecosystem.

“I’m not super excited about these traditional system integrators because the software they’re providing is of a very custom type of solutions. The international leading firms are standardising these services,” said Tatsuya Ochi, Partners Group’s head of Japan private equity.

“If you’re betting on the traditional, tailor-made solutions, there’s a chance you will be penetrated by these global players. You want to disrupt – not be disrupted.”

Going deep

There are two primary challenges from an investor perspective. First, there is the idea that cultural and language issues could limit companies’ growth trajectories to the home market. This is especially true for the less diversified SIers. Second, there is the possibility that although the market is yet to be saturated, an increase in activity could diminish the perceived upside.

“The main risk is that because of deal competition, your view of how big this [company] could be might be a little bit too rosy compared to what might really happen,” said Bain & Company’s Verbeeten.

Reservations about the digital transformation opportunity and related B2B SaaS providers compound toward the venture end of the PE spectrum. At the start-up level, there is a sense company creation is no longer contrarian or idiosyncratic. Multiple operators, each with a strong team, often tackle the same problem, and the competition makes entries difficult.

Coral Capital, which has backed the likes of staff management SaaS unicorn SmartHR, falls into this camp. The VC firm has consequently veered toward deep-tech in recent years, noting the government’s five-year plan for start-ups makes the space easier to underwrite.

Coral’s standout deep-tech play to date is Kyoto Fusioneering, an equipment supplier for fusion developers that is sometimes touted as the only commercially viable fusion company in the world. In June, Coral joined Globis Capital Partners in a seed round for Ookuma Diamond Device, a diamond-based semiconductor maker.

“We think if there’s going to be a next Sony or Toyota coming from Japan, it’s probably going to be within deep-tech, areas with a natural Japan advantage,” said James Riney, founding partner and CEO of Coral, adding that deep-tech companies had fewer cultural barriers to going global. “If you look at all the big companies out of Japan, they’re deep-tech. They’re not software.”

The key evidence here is Spiber, a biomaterials start-up that was confirmed as one of Japan’s few unicorns in 2021, when Carlyle invested JPY 24.4bn in its first minority deal. Ogura said similar deals are a possibility, but only where the technology is sufficiently de-risked.

“If the government is pushing for deep-tech, that is really positive for the overall Japanese economy,” he said. “We are not focused on investing at the R&D stage. If a deep-tech company is trying to commercialise a product, not only in Japan but globally, that’s where we can help.”

Soon others might be able to help as well – and with a wider range of risk appetites. The government’s five-year plan for start-ups has prioritised deep-tech and features provisions to bring international capital at various stages into the investment drive.

This includes a scheme to issue special visas to foreign angel investors and educate local investors about global standards in contract terms. The plan is to expand investment 10x and create 100 unicorns – there are currently fewer than 10 – by 2028.

Noriya Tarutani, head of start-ups at the Japan External Trade Organization (JETRO), a government agency, is tasked with introducing global investors to the local ecosystem. This is usually initially via LP commitments but also includes direct co-investment situations. He identified Coral and Globis as among the most active local VCs in this regard.

“The foreign investors are mostly interested in deep-tech, including industrial automation, AI, quantum, cleantech, and new materials. I think that’s partially the policy environment in Japan but also because corporates are always looking for deep-tech,” Tarutani said, estimating 30%-35% of Japanese VC investment goes into deep-tech versus less than 10% in Silicon Valley.

“It used to be easy for VCs to get LP commitments from financial institutions like pension plans, but if you look at the US, that has crashed. VCs are going toward corporates for LPs, and they invest in deep-tech start-ups.”

Foreign appetite for Japan deep-tech at the growth to pre-IPO stages is illustrated by Fiducia, a firm set up in 2020 by Tokihiko Shimizu, previously head of a government-linked private equity program for Japan Post Bank.

Fiducia hit a second close of JPY 3.86bn on its debut fund last year with support from Temasek Holdings-owned Pavilion Capital and unspecified US-based investors. The initial target was JPY 10bn. In the meantime, the firm has weighted its strategy toward biotech and medical devices, sensing a rise in competition in other deep-tech areas.

“Frankly, foreign investors understand the importance of the healthcare sector more. And recently, the yen has been very low, so they think everything is cheap,” said Shimizu, noting that five of Ficudia’s nine investments to date have been in health-tech.

Traditional transformation

The corporate strategic roots that underpin the deep-tech strengths of Japan’s VC scene also belie a broader, if more prosaic, private equity opportunity in the current environment – manufacturing.

Trustar Capital has observed an elongation of supply chains across industries due to the proliferation of AI and internet-of-things (IoT) among other areas of business digitalisation, as well as momentum in industrial green-tech trends such as vehicle electrification. Essentially, as supply chains get longer and more intricate, they become more investible.

Trustar refers to this opportunity set as the “components sector,” noting it features under-the-radar suppliers that are so specialised, they can command as much as 90% global market share in their respective niches.

Japan is a prime hunting ground for this theme; Trustar is currently raising its fourth fund in the country but has yet to decide on a target size. Fund III, raised as CITIC Capital Partners Japan, closed on JPY 30bn in 2017.

One of the key proofs for this strategy came last September with the exit of machine vision lens manufacturer Moritex to US-listed machine vision software company Cognex for about USD 275m after a nearly nine-year hold. This earned Trustar a 20x return.

Moritex was not a proprietary deal, but it proved unapproachable for most private equity firms. Masahiro Ito, Trustar’s head of Japan private equity, who is an engineer by training, believes deal sourcing and execution in such companies boils down to the ability to understand their technical merits.

“It’s not the industry or sector focus but the capability to assess why this technology is important in this value chain or business trend,” Ito said when asked if the policy push around technology made any specific verticals more interesting.

“When we invested in Moritex, almost nobody understood the opportunity. Now, it’s more obvious because many companies have longer global supply chains. What are the key technologies, materials, and components in those value chains? The number of potential deals in Japan is increasing, and compared to the past, there will be more opportunities like Moritex.”