The Journal The Authority on Global Business in Japan

Public financial markets became more volatile in 2018. For the first time in decades, every major type of investment fared poorly. At the same time, the private market in Japan saw alternative investments continue to grow, and Japan has played an active role in four key areas:

  • Environmental, social, and governance (ESG) investing
  • Direct private equity (PE) investing and secondary PE investing
  • Tools for active engagement investing
  • Regulation of cryptocurrencies

Japan’s Government Pension Investment Fund (GPIF) is the world’s largest pension fund and has allocated investments to equity index providers for strategies that reinforce the importance of ESG factors.

One outcome of Japanese Prime Minister Shinzo Abe’s reform plan, known as Abenomics, has been the require­ment for listed companies in Japan to report the number of women in leadership positions (a metric which appears to be unique to Japan).

At the request of the GPIF, global research-based indexes and analytics provider MSCI, Inc. created an invest­ment index called the MSCI Japan Empowering Women Index (WIN) that includes this data on women in leader­ship. As of the end of September 2018, the GPIF had committed a total of $22.7 billion to ESG indices from FTSE Russell, MSCI, and S&P/JPX.

Last month, the GPIF announced that it is considering raising its allocation to alterna­­tive investments over the next three years from 0.2 to three percent, which would equal $41 billion.

Japan Post Bank Co., Ltd. is also targeting an allocation of three percent of its assets—about $50 billion—to alterna­tive investments. JPB not only invests in exter­nal PE managers, but it has also set up its own direct PE invest­ment vehicle jointly with sister organiza­tion Japan Post Insurance Co., Ltd. to invest directly in PE deals in Japan and Asia.

With volatile and underperforming public markets, Japanese investors are increasing their exposure to diverse alternative invest­ment strategies, not only in hedge funds and PE funds, but also in real assets, such as infrastructure and timberland, and current income funds, such as private credit and PE secondaries.

Hedge funds have remained remarkably stable despite mixed performance. More than 11,000 fund managers are handling over $3 trillion in global assets. At the same time, these figures conceal underlying dyna­mic trends. In the first 10 months of 2018, some 477 hedge funds closed and 463 new managers launched.

PE is growing rapidly with more than $3 trillion in global assets, and addi­tional “dry powder”—or cash reserves—in excess of $1 trillion which has been raised from investors but has not yet been committed to deals.

Private credit funds are a fast-growing asset class. By some measures, assets have reached $600 billion and are projected to stretch to $1 trillion by 2020.

The growth in private credit has been driven largely by the retreat of banks from lending since 2008 and by investor appetite for current income. Japanese investors are actively allocating to this asset class, especially to infrastructure debt.

One noticeable alternative investment trend has been the growing interest of Japanese investors in PE secondaries. This strategy buys limited partnership interests in other PE funds. A typical PE fund is structured as a partnership between the general partner (the fund manager, also known as the GP) and limited partners (the investors, also known as LPs).

During the life of the fund, the LPs will typically lock up their capital in the fund for 10 years. Because a PE fund needs several years to make initial investments, during the first few years of an invest­ment in a PE fund the investors often suffer from the J-Curve, which refers to a decline in the value of their invested capital during the first few years. This happens because the LPs are paying fees to the GP but not yet receiving any invest­ment distributions.

Secondary PE investing provides a private market for LPs that seek liquidity by allowing them to sell their investments before the end of the fund. Secondary PE funds can acquire the LP interests when the primary fund has already invested and is generating income. Investors in PE secondaries can avoid the J-Curve and start to receive distributions soon after investing.

PE secondary investing is more than 30 years old. It is a highly concentrated asset class with nearly 80 percent of the secondary capital raised in the past decade managed by only 15 of the 200 or so active PE secondary fund managers.

Over the past six years, the Japan Finan­cial Services Agency (FSA) has developed the Corporate Governance Code, for listed companies, and the Stewardship Code, for investors. Both regulations have supported increased active engage­ment by global and domestic fund managers. These two codes are relevant tools for alternative investors such as hedge funds. To be sure, these codes are equally inspirational and aspirational and—as recent corporate news in 2018 has shown—much work remains to be done.

Japan has become one of the few major countries to provide regulatory guidance on crypto­­currencies. In 2016, the FSA defined crypto as a valid medium of exchange (it did not define crypto as a form of money). Japan, unlike neighboring countries, has not banned crypto activities altogether. One result of this regula­tory approach was that, during 2017, it was estimated that more than 50 percent of global trading in crypto occurred in Japan. In 2018, how­ever, that share appears to have dropped to 20 percent or less.

Even though the price of Bitcoin has dropped in the past 12 months, and many fraudulent activities have appeared around the world, Japan remains at the fore­front of global crypto regula­tions. In 2018, the FSA assembled the Virtual Currency Study Group, started to explore regulations for Initial Coin Offerings, and recognized the Japan Virtual Currency Exchange Association as a certified industry body to create guidelines for domestic exchanges. These guidelines include measures to handle insider trading, money laundering, and other standards.

The consolidation of Japanese financial institutions supports increased alloca­tions to alternative investments. Last year, Sumitomo Mitsui Trust Asset Manage­ment Co., Ltd. was formed from several related group companies to start with $600 billion in assets under management. Mizuho Financial Group, Inc. formed Asset Management One Co., Ltd. in 2016. Nomura Asset Management Co., Ltd. has merged with several group companies, and more consolidations should follow. Larger asset managers are often more international and have more human resources to look at alternative invest­ment strategies.

Overall, the general outlook remains bright for alternative investing by inves­tors from Japan.

Frank Packard is chair of the ACCJ Alternative Investment Committee
One noticeable alternative investment trend has been the growing interest of Japanese investors in PE secondaries.