ttps://www.wsj.com/articles/SB885850595438566000

By Nicholas E. Benes and David S. Milstein

Jan. 27, 1998 12:01 am ET

It’s finally happening. As economic forces push Tokyo to step up deregulation, foreign companies are starting to see more and more attractive buying opportunities in Japan. And if those prospecting take the time to look closely, they will discover that most of the best bargains are among Japan’s small-cap companies.

Bereft of capital and lacking the protection of the large conglomerates, smaller companies are leading the way in restructuring. They’re also reaching for a better corporate governance model.

Several important tidal shifts occurred in Japan late last year. First, the concepts of shareholder value and corporate governance started to take root. Second, financial institutions began to sell the stocks of less-important, often smaller client companies. As the market fell, the Ministry of Finance finally had to give up its ill-advised Price Keeping Operations (PKO) efforts, which meant that the Nikkei 225 index plunged further. Third, major bankruptcies were announced and the certainty of more became clear.

Business failures were most common among smaller- capitalized or unlisted companies, whose bankruptcies have amounted to between 2% and 3% of GNP for the past two years. In five years, approximately 10% of GNP has been destroyed by such failures.

These events have induced a new realism, which is again most easily converted into action by the more nimble smaller companies. Transactions are starting to occur. Examples would include Intuit’s acquisition of two successful accounting software companies, the merger of MKC and Stat, and the recent merger of Soft Science and six software companies. Many businessmen can now see the obvious more clearly: that “protecting” jobs and the inviolability of the company are meaningless goals if the firm goes out of business because its shareholder value is zero.

Another reason to look at smaller and middle-sized companies is that, for the time being anyway, most mergers and acquisition transactions with larger Japanese companies will continue to be fraught with many of the same obstacles that have existed so far: slow, consensus-based decision-making; sticky relationships with powerful keiretsu shareholders; ostrich-like group-think; company pride; and the sense of “betrayal” associated with the idea of selling a company. These features have produced a chronic inability to understand the full impact of low shareholder value until it’s just too late.

Smaller-cap Japanese companies do not share these problems, or at least not nearly to the same degree. They are also motivated by more intense needs to consider transactions–whether it be the need to raise new financing for the growth opportunities that face them or to refinance working capital that has been repaid to banks as part of the current contraction in lending. As a result, M&As or asset transactions with smaller companies offer more value and are more feasible to execute in terms of receptivity on the Japanese side.

The impact of the Japanese stock market’s plunge has been far more extreme among the smaller caps than in the Nikkei 225’s large-cap companies. The simple price average for the OTC was at about 12,000 yen in July of last year, but now it is running in the 700s, representing a drop of almost 40% in only five months. Many companies are now trading at multiples that price them well below their net cash value after all debt.

Much of the shareholder value which has been wiped out in the smaller caps has been the personal wealth of owner-manager presidents or company founders. To a prospective foreign acquirer, this fact brings several beneficial consequences compared to the case of large listed Japanese company.

First, there is a single dominant shareholder, usually the president, who is personally motivated to maximize his wealth. This person is used to making decisions without excessive corporate bureaucracy weighing down the process. Deep down, he may feel that the company is missing growing opportunities due to underfunding, insufficient know-how, or lack of world-wide distribution.

Second, the president and other owner-managers have the capacity to convince employees and other stakeholders to accept the deal, and “manage change” in the company after it is done. Such people don’t owe their present jobs as president or directors to 35 years of rising through the ranks, following orders and observing the status quo. These may be Japanese organizations built around the usual “clan” model, but one where the owners are still minding the house.

Third, neither the dominant shareholder nor the other influential shareholders will resist a transaction because of fears about the breakdown of mutual “cross-shareholdings” or the industry group, because for most purposes, there is none to worry about. Even if Insurance Company A and Bank B own shares in acquisition target Company X, neither A nor B will be concerned that X will sell their companies’ stock after the deal. That’s because X’s holdings are insignificant or zero. More to the point, in today’s Japan, A and B have already sold a lot of X’s stock, and will be happy to sell more. In most cases, that’s why the price of X’s stock has tanked!

Employees at small or mid-size companies are additionally more likely than their counterparts at large companies to be “manageable” after an acquisition, even though fewer managers at such companies speak English well. At smaller companies there are fewer powerful interest groups to fear, such as other large shareholders or unions. Unlike larger listed companies, smaller firms in Japan are accustomed to undertaking more dynamic strategies on smaller budgets and rapidly reacting to market changes. Also unlike large listed companies, smaller firms often have employee share-ownership plans, which means that many staff members stand to derive major financial benefits from a successful transaction.

One should note that “small capitalization” is a relative measure. It doesn’t necessarily signify a small-revenue line, and it does not imply that the magnitude of strategic opportunity from a given transaction is trivial. Many companies in this category have revenues well in excess of $300 million. Often, “small” just means “as compared to Japan’s behemoths.”

Foreign companies would do well to focus more energy on doing M&A transactions with the countless companies in Japan that fall into the “small capitalization” category. If they did, they would benefit from a higher likelihood of closing a deal and managing the transition well afterward. They would also benefit from pricing bargains that abound in Japan because of the current weakness of the stock market.