Q&A with Paul B. Kazarian, Japonica

The "secret golden goose" of legendary money managers

Rod Sparks
Originally published in the June 2006 issue

Paul B. Kazarian is the Founder of Japonica, and a Managing Director.

Given the firm's historical co-investors status as legendary hedge fund and mutual fund managers each with over $500 million invested with Japonica, is it accurate to describe Japonica as a "money manager for money managers"?

Among Japonica Partners' earliest co-investor limited partners were – "the two Michaels" – Michael Steinhdardt and Michael Price. We would agree that having two accomplished money managers, considered by most to be even "legendary" money managers, each with over $500 million invested with another manager is very likely to remain a without peer global benchmark.

However, we view ourselves as entrepreneurs, not money managers. For example, entrepreneurs are reluctant to stockpile assets unless the assets can be effectively employed to provide entrepreneurial investment returns. Consistent with our entrepreneurial co-investor business model, Japonica has passed on many investment situations that do not offer opportunities for entrepreneurial returns.

How do "entrepreneurial returns" compare to top quartile performance?

"Entrepreneurial returns" are by definition a multiple of 3 to 4 times either top quartile hedge fund and top quartile private equity returns. The business of providing entrepreneurial returns demands that you have an entrepreneurial business model. It is simply not possible with an AUM business model.

As a GIPS compliant firm, selective disclosure of performance track record information is precluded. Importantly, disclosure of "all" performance information is exclusive to prospective Japonica co-investors. Japonica's GIPS performance report is a 25-page report of transparent, comparable, and highest integrity performance information that covers all of Japonica's co-investments since inception in 1987.

How do you respond to the comment that Japonica's historical co-investors view Japonica as their "secret golden goose"?

Our historical co-investors are accomplished money managers who are loyal and defiantly protective of our relationship. They have the highest regard for Japonica's entrepreneurial business model, which has created approximately $2 billion in shareholder wealth.

When an accomplished money manager really aspires to become legendary, entrepreneurial returns that are 3 to 4 times top quartile on large dollar positions are essential to achieve the legendary status.

Is Japonica's entrepreneurial co-investor business model as straightforward as its geometric diagram and why can't others replicate it?

The first thing we do when we sit down with any new relationship is to make sure they understand our entrepreneurial co-investment business model. It's imperative that people we work with fullyunderstand our business model and what being an entrepreneurial co-investment firm that makes concentrated investments in underperforming global large caps, providing entrepreneurial returns for accomplished money managers who succeed with top quartile performance means.

The geometric diagram is a useful tool to help people understand (1) the best traits Japonica shares with hedge funds and private equity firms, (2) the insidious features of both hedge funds and private equity that Japonica avoids, and (3) most importantly, the entrepreneurial traits and Co-investor structure that makes Japonica so special.

With respect to others replicating Japonica's business model, providing entrepreneurial returns for accomplished money managers who succeed with top quartile performance requires all three of Japonica's core competencies as well as a firm-wide belief in the power of perfectly aligned economics with co-investors.

Some even say the passionate intensity and relentless drive required by the business model takes years off your life.

These are radically high barriers for other firms to replicate.

Could you elaborate on Japonica's most important entrepreneurial traits and the most important elements of its co-investment structure?

The most obvious benefits of the entrepreneurial co-investment business model are aligned co-investor interests and the cultivation of entrepreneurial returns.

The entrepreneurial traits are highlighted by the firm's "DCC" core competency and years of global "R&D" discovering opportunities to achieve entrepreneurial returns.

The co-investor structural traits include a range of carefully vetted top quartile hurdles, suppressed non-aligned fees, and highest integrity cash-on-cash metrics. Japonica team members who assume positions with a control investment forego industry standard incentive compensation, avoiding the pervasive misalignment of interests often seen with excessive bonuses, perks, stock options, and restricted stock grants. This keeps management teams singularly focused on the importance of creating entrepreneurial returns.

The structure is mathematically and financially superior in the much higher gross to net returns to the co-investor. It is the structure of choice for accomplished money managers.

Is it accurate to say with Japonica's business model, it basically "works for free" if its returns do not exceed Top Quartile Hedge or Top Quartile Private Equity?

Our convictions in Japonica's business model are reinforced by Japonica's pre-control and control investment successes in the diversified, consumer products, and transportation sectors.

Japonica's business model economics instill rigorous discipline and restrain investment unless significant opportunities are present. Our co-investment structure and top quartile hurdles demand that we pass on situations that offer only top quartile returns. While top quartile performance constitutes success for most money managers, our teams know that with only top quartile performance, there are no excess profits to be shared.

It truly is a revolutionary business model. It actually cultivates entrepreneurial returns.

Don't accomplished money managers view co-investing with Japonica as a superior alternative to the high cost and performance risk of adding another internal group?

Yes. Especially if their goal is to achieve that status of legendary, which the alternative of adding another internal group does not offer.

Accomplished money managers gain the comfort of a track record of entrepreneurial returns, they don't have to share their annual management fees or add an additional layer of management fees, and they love that there is no profit sharing unless returns exceed top quartile.

We've heard accomplished money managers describe itas "alignment utopia."

There is a lot of attention paid to alignment of interests. How does the co-investment model compare to benchmark hedge fund and private equity models in terms of alignment?

The co-investment model offers a clean sweep of the 20 most important alignment terms for economics, structure, and governance when compared to either hedge funds or private equity.

From the perspective of accomplished money managers, it's alignment utopia. From our perspective, the co-investment model actually cultivates entrepreneurial returns 3 to 4 times top quartile.

Could you explain how Japonica's DCC core competencies enable the firm to add so much value?

Japonica's core competencies are "DCC": Discovering Value Gaps, Changing cultures & operations, and Creating value through hands-on management. Consistent through out each of Japonica's major situations including The Chicago Northwestern, Allegheny International, Sunbeam-Oster, and Borden is DCC. The common denominator among Japonica team members is that they all have "DCC in their DNA."

Discovering Value Gaps where others have walked away is one of Japonica's three core competencies. Our teams discover – through years of research and analysis – sizable ROIC and operating improvement opportunities.

Changing Cultures is Japonica's special core competency, creating value through changing both internal cultures as well as external expectations. Changing cultures offers the greatest challenge and opportunity to close Value Gaps.

Our experience is that the value creation calculus of changing cultures and expectations provides greater value creation in and of itself than the entire top quartile returns of either hedge funds or private equity.

Creating Value through hands-on management is Japonica's third core competency. Japonica core management teams assume key corporate and operating positions in control investments to create value and manage the unexpected.

Providing entrepreneurial returns 3 to 4 times top quartile requires all three of Japonica's core competencies and entrepreneurial co-investor business model.



In comparing Japonica's "DCC" value-added or alpha creation to the sources of value-added of both top quartile hedge funds and top quartile private equity firms, there really is no comparison.

Given Japonica's sole focus on making concentrated investments in underperforming global large caps, where does Japonica currently see the biggest opportunities?

Of course regarding investment situations, we don't talk prospectively. Japonica continues to remain consistent with its history of concentrating management and investment resources on a limited number of major situations. We select situations always keeping in mind that changing cultures offers the greatest challenge and opportunity to close Value Gaps.

That said, Japonica remains true to its heritage of focusing on three sectors — diversified, consumer products, and transportation.

Is the fact that Japonica's performance is so stellar what motivated the firm to adopt the highest standard of performance reporting?

Japonica's largest historical co-investors are based in the U.S., and our view is the world is global, so should our co-investors. Japonica has aggressive growth plans for concentrated investments in underperforming global large caps, and GIPS is endorsed as a "global passport", facilitating greater comparability and integrity of investment returns.

The CFA Institute developed the Global Investment Performance Standards in conjunction with local sponsors including Swiss Bankers Association, The Hong Kong Society of Financial Analysts, and The Security Analysts Association of Japan. Having entrepreneurial returns audited in accordance with GIPS has become extremely valuable as we work our selection process vetting accomplished money managers who succeed with top quartile performance, especially in Europe and Asia

Given the expanded number of accomplished money managers who can meet Japonica's minimum of $250 million, does GIPS allow Japonica to be even more selective in accepting its co-investors?

Domestically we have a 10-year waiting list of co-investors seeking to partner.

The explosive growth in the number of accomplished money managers who are potential co-investors is extraordinary. We are seeing a ten-fold increase in the number of large, value-added co-investors capable of making a minimum $250 million co- investment with Japonica, especially in Europe and Asia. Japonica historical co-investors offered not only a manageable misappropriation risk, a level of successful investor reputation, and a degree of capital markets clout, they contributed other areas of value-added from their own global networks including strong business linkages, close connections to global retailers, and strong government relationships.

With GIPS, Japonica is in the position of being able to continuously improve and increasingly globalize our highly selective co-investor selection process with the highest value-adding in and the lowest value-adding rotated out or cut back.

Why do Japonica's co-investors view being the largest and first over-a-billion private equity and among the first over-a-billion with hedge fund traits GIPS verified to be such a seminal event?

The smartest investors have long been troubled by the inability to reconcile the touted return for hedge funds and private equity in the media with the meager returns they notice in their bank accounts.

What does Japonica stress the CAKE Foundation look for in selecting managers for its $52 million alternatives mandate in 2006?

Japonica's Founder and Managing Director Paul B. Kazarian created the private operating foundation in 1993. Last month CAKE mandated $52 million alternative assets for 2006 and is currently vetting U.S., Europe, and Asia hedge fund and private equity managers with selections planned for third and fourth quarters of 2006. CAKE's 2006 $52 million mandate is 18% of the Foundation's $291 million projected five-year alternative asset mandate.

Three of CAKE's most significant initiatives are Japonica InterSect (a global benchmarking and best practices firm that focuses exclusively on developing economies intersectoral commerce), New Philanthropy Benchmarking (providing wisdom for the passionate Capitalist-Philanthropist), and Community Micro-Commerce, with a special focus on the disabled in developing economies.

Since CAKE is precluded from investing with Japonica Partners it will invest with the next best alternative.

Japonica has benevolently assented to support CAKE, pro bono publico, in vetting managers. CAKE is vetting managers based on the following criteria and weighting: alignment of interests (50%), performance track record (40%), and investment strategy (10%). Of course, CAKE is using the GIPS framework to assess the bona fides of accomplished money managers.

Further, the Foundation expects significant allocations to entrepreneurial managers who can create financial alchemy from CAKE's own value-added and global network as a strategic co-investor.