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Japan, Where Capital Flows to Yesterday’s Companies

In the next couple of weeks, bondholders will vote on the fate of Covalent Materials, the Japanese technology group formerly known as Toshiba Ceramics, which was the object of a leveraged buyout in 2006. Since then, the company’s earnings have halved as competition from lower cost producers has ratcheted up and the company’s technological edge has become duller. Debt that was sustainable in more profitable times has become too burdensome today, even with Japan’s long-term zero interest rate policy.

Employees assemble parts for Fujitsu
Bloomberg | Getty Images
Employees assemble parts for Fujitsu

If the bondholders vote against the company’s proposed financial restructuring, Covalent will be heading for the bankruptcy court. So far, only a handful of Japanese companies have been felled by Japan’s two lost decades (and counting).

A few months ago, chipmaker Elpida was sold to Micron Technology after it finally ran out of time. Today, consumer electronics company Sharp is struggling to avoid an equally unhappy end as rating agencies cut its debt to junk and it struggles to renegotiate a deal that will see Taiwan’s Hon Hai take a 10 percent stake. In July, Sanko Steamship filed for bankruptcy with $2 billion of debt – a victim of shipping oversupply, rising fuel prices and declining freight charges.

Meanwhile, the airline JAL, the largest Japanese company to go through the bankruptcy process, will soon relist as a leaner, more profitable entity than it has ever been before.

As Japan’s economy continues to grow only marginally(next year GDP is expected to fall to below 1 per cent), these companies are likely to be joined by others who have finally run out of time, unable to pay even the ludicrously low rates on their debt.

Thus far, businesses with some nous should have been able to refinance their debt, according to James Sprayregan of Kirkland & Ellis who worked on the JAL restructuring.

Now, a mixture of cyclical and secular factors – such as demographic change and ever higher energy prices – are finally taking their toll. In the face of such intractable factors, Japanese companies are finding that their once awesome technological edge is no longer enough.

Covalent may have survived the decline in its profitability, but this and the debt that its private equity owners – Carlyle and Unison, a local Japanese buyout firm – put on the company eventually proved lethal. Carlyle and Unison paid Y91 billion when they bought the company, with an equity investment of Y20 billion.

Covalent may have been able to continue shrinking in the genteel Japanese way were it not for the fact that the company issued bonds when it was taken over by its new owners and these bonds come due for repayment in February (the bonds did not have terms that would allow bondholders to pull the plug earlier).

In most countries, robust restructuring and bankruptcy processes are an inherent part of a healthy economic ecosystem. But that fundamental point still isn’t really accepted in Japan.

Japanese banks still take pride in their support of ailing clients. But that has a cost. It means that capital generally flows to yesterday’s firms rather than tomorrow’s – whether in Japan, or outside. To the extent that there is little demand for loans in Japan, the banks’ preference is to put their excess money into Japanese government bonds rather than to find deserving borrowers outside the country.

Even as European banks pull back from lending in Asiaoutside Japan, Japanese banks generally prefer to buy their loan portfolios at a small discount in the secondary market – rather than expanding their own presences and taking advantage of the fact that, in many cases, they have access to more dollars than many of their rivals.

Covalent partly paid down its bank debt by selling its silicon wafer business to a Taiwanese company. But it, and many other companies, haven’t really got to grips with the fact that the entire Japanese market is shrinking and Japan as a production base is no longer competitive.

As an airline, JAL is in a globally competitive industry, and one in which the economics of many of its rivals are far better than its own. In bankruptcy, it had advantages that other Japanese companies lack – such as the support of Development Bank of Japan (a policy bank) and government-owned Enterprise Turnaround Initiative Corp of Japan, which together put up $5 billion of post-filing financing.

But every company in the world – even the best Japanese company – today faces global competition. To be successful in a Japanese world is no longer enough.

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