In Japan, the question of value creation has become increasingly important as corporate governance evolves and Japanese industry restructures in the era of Abenomics, Prime Minister Shinzo Abe’s plan to jolt the world’s third-largest economy.
One quarter into 2016, we’ve already seen significant events and trends. These include the Bank of Japan’s surprise introduction of negative interest rates — which may be more negative than positive for risk assets. We’ve also seen Japanese companies intensify their focus on exporting to contend with China’s shift toward high-value-added exports from lower-value-added ones, as outlined by our colleague Henry McVey.
But the structural reforms of the third arrow, the final installment of Abenomics’ three-pronged economic strategy, have prompted national corporate champions to actively explore spinning out noncore assets in a bid to propel core business growth. That is one trend that will likely grow.
Whether positive or negative, these events certainly make for exciting days. As private equity investors, we have the good fortune to meet weekly with the chief executive officers and management teams of leading companies to discuss opportunities. These executives inevitably want to know how we can help them drive growth and create value despite macroeconomic headwinds.
The topic of value creation is, of course, a favored subject of private equity investors worldwide, but it is particularly meaningful to Japanese companies today. Looking back, we at KKR have found that Japanese corporates have consistently delivered a much lower return on equity compared with their peers in other markets, as measured by the ROE averages of Topix, Bloomberg European 500, S&P 500 and FTSE 100 companies. This is no longer acceptable. Now, Japanese efforts to outperform in the current environment are all the more difficult.
As Japan’s companies produce truly world-class products and services, this underperformance ought to be an anomaly rather than the norm.
Much of these lackluster equity returns can be attributed to weak corporate governance standards. These in turn have led to management teams that struggle to handle a globalizing business environment, operational inefficiencies, a lack of transparency, a lack of learning from and incorporating global best practices and inadequate capital allocation and shareholder returns at otherwise promising companies.
Before Japan adopted its official Corporate Governance Code this past June, there was little impetus for even public companies to appoint independent board members. This practice of keeping all business decisions insular has been counterproductive to growth: Directors who have limited incentive to make tough decisions in the short term don’t institute practices that can lead to long-term gains.
We are, however, hopeful for a new era of proactive business leadership going forward. The Corporate Governance Code now mandates that companies listed on the first section of the Tokyo Stock Exchange, the section for the largest-cap corporations, have at least two independent directors on their boards — and if they don’t, they must be prepared to explain why not. Already this has driven the proportion of first-section companies with independent directors to rise from 74.3 percent in 2014 to 94.3 percent in 2015, according to the Japan Exchange Group, which operates the Tokyo exchange. The code additionally aims to bring Japanese accounting standards closer to those in the West and improve transparency by asking corporations to provide English-language disclosures.
The code’s adoption has been a positive development, and one that is coupled with the introduction of the Financial Services Agency’s Stewardship Code, launched in 2014. The Stewardship Code is a set of principles aimed at promoting best practices in the ways that institutional investors discuss, disclose information and interact with the companies in which they invest. To date, approximately 200 investors have pledged to adhere to the code, including KKR.
These two initiatives are poised to enhance companies’ governance practices and investors’ engagement with companies, which should lead to greater accountability. If common shareholders have a voice through more proactive investor relations practices and independent directors’ views are taken into account, business leaders will make sounder decisions regarding the use of funding and promoting capital efficiency. They will also be more apt to assess whether businesses should remain part of a company or be spun off to generate greater returns — and then share those returns with investors.
Management will be challenged and must prove that it is equipped to lead a corporation. It is best global practice for CEOs and boards to be held accountable for their decisions and justify why their actions are good for their investors. Likewise, they should expect scrutiny if they do not.
Yet these are still early days. Within the first months of the code’s existence, questions have arisen regarding how independent these independent directors truly are. Are these directors speaking up, and are they being heard? Also, there needs to be enough viable independent directors to populate these boards, yet the pool of highly qualified executives with the gravitas to voice contrarian views is shallow. Investors, too, need to speak up and cast off their institutionalized passivism.
Regardless of these challenges, a greater focus on corporate governance is positive and will be highly beneficial to Japan’s economy in the long term. Put simply, enhanced governance standards build confidence and attract investment from Japan and overseas. Given the recent market turmoil, global investors are seeking high-quality securities and companies in which to invest that can generate safe and consistent returns. Attracting these investors leads to long-term economic gains and enhanced competitiveness — both of which are critical for Japan’s continued success in the face of dramatic demographic change.
And in the short term, enhanced corporate governance practices will help companies better ride out market volatility. Freeing up capital to be put to use efficiently is a valuable strategy, particularly if market turmoil continues well into the future.
At this critical juncture, Japan’s focus must be on creating a business-friendly environment to promote investment. Government can do much to support such measures, but individual corporations and their leaders must be more hands on in taking the tough measures to meet key corporate objectives and generate attractive returns. It is up to everyone in the business community — from common shareholder to CEO — to encourage the development of corporate governance in Japan.
Andy Saito is chairman, and Hiro Hirano is CEO, of KKR Japan in Tokyo.
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