from the inside, looking in

Where is the Japanese IPO market headed this year? February 28, 2008

I predict that the Japanese IPO market is going to be very quiet this year. There were 121 IPOs last year, and a start of year survey of market professionals by the Nikkei saw 15 out of 39 respondents suggesting that we should see 100-120 IPOs. Just under 20% of respondents said the number was going to be <100. This would mean that around 40% of “professionals” think we might get more than 120 IPOs this year.

Yeah, right.

Try somewhere south of 86, which is the number in 1998.

The general uncertainty surrounding the financial markets doesn’t help and the IPOs so far this year have been dismal. Out of 7IPOs, 5 floated below the offer price (and have not made progress since).

There is also likely to be a one-off moratorium on IPOs at the end of the year, due to the transition of the scheduled introduction of electronic stock certificates in 2009. Estimates for the moratorium range from anywhere between 1~3months. Given the competence of the TSE in IT related matters, I would guess it will be at the long end of that range.

What that will mean is that the listed VC firms are likely to come out with bad numbers this year, with a real likelihood that some will plunge into the red.

Will Japanese VCs finally realize that the game has changed, and they need to change their business model? We shall see, but I am less than optimistic.

The old school firms have traditionally mostly engaged in a “spread it wide and thin” strategy, and have benefited from the increased IPO activity mainly in the new markets set up to allow smaller (but allegedly growing) companies to list.

However, my personal opinion is that it would be foolish (and plainly wrong) to expect the same throughput of IPOs going forward. Since the listing requirements were relaxed, we have had a significant number of companies listing due to a “flexible” interpretation of listing requirements by underwriters and exchanges, especially with regards to the fact that companies should have the potential for high future growth. Post-IPO performance for too many companies has been poor, as their growth has disappointed investors. I believe that underwriters and the exchanges have a lot to answer for. Now the average investor has caught on (the fact that private individuals make up so much of the volume is also a problem, given the size of companies and the relaxed regulations), hitherto inflated valuations have come down to more realistic levels.

The “new school” VC firms, either independent or affiliated with newly cash rich firms who got out onto the market when the valuations were still frothy, do not escape the change in investor sentiment. There have been too many hyped IPOs where investors comprised a significant proportion of the customer base. Drecom, which listed 2 years ago, is a perfect example. Drecom, at its post-IPO peak, was worth about $1B. Two years later, it is worth less than $40M. And in its second year as a public company (year ending March 07), posted a loss of nearly JPY249M on sales of JPY843M. The previous year saw a profit of JPY256M on sales of JPY703M. The year before that, it was JPY89M on sales of PY238M. Funny how the growth stagnates (and profits fall through the roof) pretty much as soon as the company lists. And public market investors appear to have caught on.

To put it bluntly, this is just one example of a case where the interests of the company, investors=customers, and underwriters were aligned, and were able to take advantage of the market’s naivety (easy to do when the majority of players are OAPs, housewives or people looking for an alternative for the pachinko parlour or horses) by creating a growth story and unrealistically insisting that the curve will continue post-IPO. I can’t imagine that the insiders were not well aware of the reality of the situation.

This kind of IPO is easy when you have companies able to list on single digit $M sales, and you have a large/cash rich customer/”strategic” investor who is willing to buy services preferentially from you in return for a potentially valuable equity stake. But this model only works when the valuations are in arithmetically silly territory, and the net sum required to be injected into the company (via equity and also via buying services to pad out the company financials) is likely to be less than the capital gain achievable in an IPO. If a company required sales in significant double or even triple digit $M territory, there just aren’t that many companies who could (and would) engage in this kind of financial engineering.

Everyone appears to still be turning a blind eye to this kind of behaviour, even though the pattern is clear to see. Pre-IPO investors and insiders may win, but investors (again, mostly private individuals) lose. I do understand the whole caveat emptor thing, but you can’t invoke that if you are saying that the market IS regulated (which it should be).

The failure of market regulation is clear to see. More than that, there is more than a whiff of market manipulation and even maybe fraud in the air. If this were the US, we’d have seen a bunch of shareholder lawsuits already.

The valuation hyping is aided and abetted by NO and also the media (and retail securities firms), which seems to be populated with way too many novices from the naive tat they churn out – that is of course if you believe that they aren’t also in on the game….

And yet the politicians, bureaucrats and market insiders keep going on and on about how to reassert Japan’s presence as a major financial hub. The Japanese markets, especially at the lower end, lack credibility. Without changes to the system (even if it means seeing a drastic cut in IPOs), savvy financial investors aren’t going to touch these markets with a bargepole. I can’t help thinking if it is all one big conspiracy to suck financial assets out of peoples’ saving accounts and into the pockets of certain interests.