Sandringham Capital Partners Limited

Catching the new wave of reform in Japan

Simon Kerr
Originally published in the June/July 2005 issue

Students of business in Japan would are very familiar with the term keiretsu, an arrangement whereby the suppliers and local bankers to a Japanese company are intertwined through long-term relationships and cross-holdings. These business groupings were mutually supportive and beneficial during Japan's post-war rise to economic power. Over several cycles there was a prolonged ascent by internationally competitive Japanese companies that were driven forward on a mantra of growth; in microeconomic terms they were "sales maximising" firms.

The extended boom of the 1980s found its apogee in Japan – the stockmarket bubble, and the gold leaf in sushi and liquor. But in the late 1980's it was the father of Sandringham Capital founder Koji Fusa who liquidated his equity and real estate holdings, providing a lesson on the sale of assets that has been useful over a lifetime.

Getting over the hangover

The legacy of the boom times has been a prolonged slump in Japan Inc. as various excesses have had to be worked off through time. The perceived bottoming of sectors within the Japanese economy has created opportunities for different sorts of investors. From 1998 onwards domestic banks were sellers of distressed loans to the smart money (Cerberus, Goldman Sachs, Lonestar and Morgan Stanley). In the late 1990s foreign private equity firms like Ripplewood, Warburg Pincus, and Whitney were measuring up Japanese companies, and opening offices in Tokyo. The landmark deal was the purchase of Long Term Credit Bank of Japan by Ripplewood with government guarantees and puts on parts of the loan book.

At the turn of the millenium central Tokyo real estate values were thought to be bottoming, potentially ending the downward spiral of lower asset values and higher non-performing loans for banks. Around the same time (autumn 2000) Unison, a private equity group established by a former Goldman Sachs partner, John Ehara, launched a bid to purchase wholesale liquor group Daimon, in what was the first quasi-leveraged buy-out of a listed company in Japan.

In 2000 and 2001 there was a sprouting of long/ short equity hedge funds dedicated to Japanese markets, some based in Tokyo but others in London or the United States. The flowering of these alternative investment strategies might suggest that Japanese finance was catching up with the West, but as is often the case, the extant culture of Japan is slower to change than that. The Japanese system is designed in part to prevent aggressive takeovers, and any takeover involving a foreign entity. Such unwelcome interventions would disturb the calm waters of Japanese finance and management. In Japan, corporate raiders are seen as greed-driven cowboys out to make a short term profit rather improve long term returns.

But change is underway. "Corporate governance" is a phrase with new relevance in Japan. The managements of many quoted Japanese companies have publicly stated the need to improve returns on capital. There are not necessarily jobs for life anymore: there is unemployment as well as under-employment in Japan. The old relationships between corporations do not mean the same as they used to – the cross holdings are being unwound, and the "dedicated" suppliers are having to find new customers. The strategic goal of corporate Japan is no longer to maximise sales, but for many firms it is to improve returns on capital. Now Japanese company managements have begun to talk about their stakeholders, and about shareholder value. The maverick shareholder activist Yoshiaki Murakami has characterised the new attitudes. He said recently that "we're in a transitional phase. In Japan, change starts out slowly but then accelerates."

Sandringham Capital Partners

Riding this wave of change is Sandringham Capital Partners, the brainchild of Koji Fusa, a Japanese financier who is applying Western style advisory and financing skills to the world's second largest economy like a gaijin. "We're replaying some of the strategies and tactics used in the 1970s and '80s in the American and British stockmarkets," he discloses.

While electronic in-trays are full of invitations to conferences discussing the coming together of private equity and hedge funds, Fusa, a 45-year old former head of investment banking for CSFB in Japan, is actually doing it rather than just talking about it. "We are not a hedge fund," he says, "we have a hybrid approach to Japan. The term hedge fund has bad connotations in Japan, and we do not do what a typical long/short hedge fund does in Japanese equities."

Like other activist investors Sandringham identifies attractive companies on the basis of value criteria, and builds stakes in companies. The differences come in several areas. These are engagement, portfolio construction, the exit mechanisms used, and how the fund structure relates to the time-frame for investment.

Sandringham's core universe of publicly quoted companies are ones with which Koji Fusa – or one of his research partners, Ryotaro Kawashima and Kiyofumi Nakano, have built up strong relationships with over many years, based on past advisory work and trust. Most activist shareholders do not truly engage with company managements, rather they tend to parade outside the citadel and tilt their lances. Fusa, on the other hand, uses his trusted position to work with the management teams and/or significant shareholders to extract value from these companies. His partners have been carefully selected not just for their advisory skills, but for their complementary networks of company contacts, and he has in director Taro Kaneko a door-opener of considerable repute.

The concept is that Sandringham Capital Partners has enough manpower to cover a sufficiently large universe of publicly quoted companies (around 100 in the core universe, 500 in total target list) to ensure that it can allocate the desired level of capital. Since the inception of the fund, the original list of target companies has been enhanced as more and more opportunities are being brought to Fusa and his colleagues from intermediaries and, pointedly, from company management teams directly.

Koji Fusa is very clear on the practical limits of each of his people networking in this way. "We have to be right on top of our analysis of the companies where we are invested. So that means each of our investment team may have up to ten companies where we have capital committed. We each track about 100 companies, mostly from the core list, and then a number of the special situations which make up a proportion of the universe, but fall outside the core….For my part, I met a total of 128 CEOs of Japanese public companies last year."

The Tokyo based Research Consultants Kawashima and Nakano were respectively Head of M&A in the Corporate Finance Division of Credit Suisse First Boston (Securities) Japan Ltd., and Head of the Structured Products Group at UBS Japan.

These close relationships and the expertise of the Sandringham staff in M&A may give the firm an advantage versus buy-and-hold value managers. The creativity and access of the new team has the potential to create the catalyst for change in the companies in which they hold stakes. Usually external foreign shareholders are considered to have interests too far away from extant management for the same to apply.

Portfolio construction

The portfolio construction that Sandringham will utilise will become evident when the fund is matured. It is anticipated the balance sheet will always be long-biased, and that in the course of a year the Sandringham Fund will get to 100% net exposure, for example, 150% long and 50% short. Whilst the percentages of the shares of the companies held will vary with market capitalisation (say 5-20% of the voting shares), a single position could, unusually, comprise 20-25% of the equity of the Sandringham Fund, and it is likely that there will be several positions within the same sector.

By contrast a private equity fund will probably have fewer larger stakes in companies than the Sandringham Fund. A Japanese equity hedge fund will have anything from the 40-60 positions of a Henderson Japan Absolute Return Fund or Odey Japan & General, right up to the hundreds of positions maintained by the Whitney New Japan Fund.

Exit mechanisms

Part of the skills of a private equity operation are vested in timing the disposal of holdings and finding suitable buyers. Equity hedge funds tend to limit themselves to sizes of positions that are readily tradeable, say 80-90% of the portfolio could be liquidated in 3-5 days. So while private equity companies may find a trade buyer or use the public market for an IPO, hedge funds overwhelmingly accept the liquidity restrictions of the traded markets. Sandringham Capital Partners has adopted a mind-set that is flexible enough to embrace both.

Unusually, the principals of the firm are very focussed on the exit mechanism as well as the exit price/valuation of stakes taken. This focus is evident from the label they have given themselves, "Investment/Exit Professionals". Indeed, in the way they analyse exit options as well as valuations prior to making their investments, they are again more akin to private equity investors than to hedge funds. In this particular area the experience of Kiyofumi Nakano is very relevant as he has been described as a pioneer in structured monetization of public companies. During his time at UBS Warburg in Japan he worked with the firm's corporate finance group to capture capital restructuring opportunities including share buybacks, leveraged re-capitalization, LBOs and MBOs. Included in the background of Ryotaro Kawashima is a period leading a team at Morgan Stanley Dean Witter (Japan) that specialised in the execution of capital markets transactions and private placements, again a good experience to bring to bear for disposing of Sandringham's positions.

Fund structure and time-frame

The time-frame for value investors is well-known to be long. Whilst value investing style wins out over growth-style investing in the long term, the periods for which the value is not recognised in security prices can be measured in years. Hence the concentration on "value with a catalyst" these days. The Sandringham Fund will have some holdings in the portfolio for over a year, and a small minority turned over quickly. As is the case for any funds that bridge the gap between hedge funds and private equity the terms of business of the Sandringham Fund have to reflect the limited liquidity of significant stakes in companies. The 2% annual management fee and 20% performance fee are not unusual in the hedge fund industry. Redemption of capital can be done quarterly, and there is a 2% fee for any redemption in the first 18 months after initial subscription. In addition a 2% fee is applied for redemptions in March, June and September – there is no fee for redemptions at year-end. According to Fusa, the blocks that would have to be traded to accommodate redemptions could be executed within the 2% fee margin within a week. The liquidity of these sorts of holdings has been tested in the early stages of the fund. Exit strategies have been implemented on 35% of the portfolio within five months of inception, so keeping the upside potential of the fund intact even though returns to date have been ahead of target.

Recyclable ideas

Although it may be seen that the activities of Sandringham Capital Partners are transaction driven, that is not how they are viewed within the firm. "We use recyclable ideas," enthuses Fusa, "so we can apply the same strategies used on the situation of one firm in an industry and apply to other firms in the same industry, and to other sectors. Also we believe that our relationships with senior corporate executives increases the chance of coming back again with creative solutions for the problems founder shareholder or family shareholders have in owning a quoted company. We are not doing something to an existing management, so much as working with them to help them realise their major asset or to have its value appropriately reflected in the price."

One of the edges that can be exploited by the team at Sandringham is their expertise in valuation. Takeout values and private equity valuations are focused on cash flow. This is something akin to the metrics that help Warren Buffett determine the true underlying value of his investments: What would a buyer of the whole company be prepared to pay for this stock? Like Buffett, Sandringham is prepared to go out a period of years to suitably assess the value of the growth of a company. Quite often this comes down to an understanding of the cash flow return on invested capital, and marginal returns on invested capital. These are the characteristics of a company's financial statements that are well handled by the HOLT system that Fusa and Kawashima became familiar with at CSFB.

The HOLT system produces a warranted price for stocks/companies, i.e. a fair value estimate. The in-house estimates of warranted value across the core universe have been calculated already. This allows the portfolio managers to act quickly when company or market events produce an opportunity to acquire stock when it becomes available at short notice.

The Sandringham Fund has just over $100m under management and the managers are hoping to build this to $500m. With leverage there would be $750-1,000m to deploy, thus giving the $50-100m unit size for investment that gives real clout with companies. The absolute size of holdings will effect the shape of the fund as it builds: " We think it will be better to have 10 rather than 30 holdings so we can carry more weight in discussion with board members," says Fusa.

Risk controls

The risk controls for the Sandringham Fund are not typical for equity-related hedge funds. They use the typical risk analysis tools for hedge funds in order to know what these funds would think. However, there are no price stops, and the downside risk constraints are from the qualities of the stocks: solid book values and attractive price to book ratio; a yield if there is one; and that positions are only acquired when they already present attractive value characteristics (inexpensive multiples of cash flow and cash earnings). In the context of this fund, three-times cashflow is an attractive entry valuation and a 10-times cashflow multiple would be considered an attractive exit level. Fusa puts it that " the implementing of stop losses by hedge funds can create interesting opportunities to buy as shares tend to undershoot. Our risk control has focused on 'real risk' rather than 'perceived risk' which heavily relies on our in-depth knowledge of the companies we own pieces of."

The Sandringham Fund has a more concentrated portfolio than most equity-related hedge funds in terms of the number of holdings. The holdings may be in a limited number of sectors, making it likely that there will be several holdings in the same industry, and so the portfolio constituents will show co-movements in price. Add to this that the balance sheet could well be 150% long and 50% short, and the Sandringham Fund will probably put more capital to work at one time than most long/short hedge funds. The portfolio is less liquid than most hedge funds, and it is unlikely that a fall in the share price of a long holding will cause the portfolio managers to cut positions to stem losses. Putting these operational characteristics together, it is clear that the time-series for the monthly returns of the Sandringham Fund will contain larger numbers than most equity hedge funds, both positive and negative.

Since launch in early-February the Sandringham Fund has indeed produced big monthly numbers. By the end of June the estimate of performance put the fund up 20% over the nearly five months since inception. Over the period February to June the ABN Amro Eurekahedge Japan Hedge Fund Index was up 3.28%. "We are pleased with progress to date," states Fusa, "but we do target an annual return of 40% over the long term. So we are in line with the kind of returns we need to get there."

Surf's up

The approach to investing in Japanese companies taken bySandringham Capital Partners is unusual. It truly is a hybrid that is neither a private equity vehicle nor the usual style of equity hedge fund. The wave of reform sweeping through the boardrooms of corporate Japan after a deflation of 15 or more years is powerful. A key question is whether it is feasible to put in place an appropriate fund and money management framework to ride that wave through to the beach and some sort of maturity. The question the approach of Sandringham Capital Partners asks of hedge fund investors goes to the heart of their own commercial prospects: are investors insightful enough to recognise the opportunity, and capable of living with the volatility that may be necessary to get to the end-point with the surf championship medal in hand?

The kind of positions that Sandringham takes on

1. A privately negotiated convertible bond

  • A three-year ¥7billion EuroYen convertible with a re-settable conversion price set mechanism which lowers the volatility while likely to maintain over par price of the bond
  • The only written research on company in last four years was by one analyst two years ago
  • CSFB led an IPO in the same sector as the issuing company in 2000 giving the Sandringham professionals familiarity with the competitive situation
  • Parallel with a situation three years ago in which a company was abandoned by the stock market even though it had a powerful story based on the roll-out of a capital spending program – that share halved over 12 months then went up seven-fold in two years
  • The President of the company has known the Sandringham management for five years, giving them more credibility than other potential investors, including investment banks
  • Exit strategy is in place from the outset

2. A privately-negotiated purchase that clears a stock over-hang

  • Selling from former insider put a lid on stock price of company with no apparent sell-side coverage or significant institutional ownership
  • 10-15% of the issued share capital bought by Sandringham at a 7% discount to the morning session close
  • The block trade not just cleared out insider sellers, but changed perception among traders. The stock traded limit up for a couple of days in a row and subsequently went higher yet.