Japan's Empire Builders

The curious case of Japanese M&A and stock returns

By: Taiki Morita & Nick Schmitz

Empire building has been out of fashion in Japan since General MacArthur retreated from the Philippines in 1942, and we’re not just talking about military acquisitions. Japanese CEOs engaged in far fewer mergers and acquisitions than CEOs in other developed countries since the 1989 asset bubble.

Michael Mauboussin highlighted the extreme disparity on mergers and acquisition spending between Japan and the rest of the world in the chart below.

Figure 1: Capital Allocation for M&A, % of Sales

Source: Mauboussin

Wall Street analysts and international finance experts find this statistic deeply troubling. Their critiques of the lack of corporate mergers and acquisitions reads like uyoku dantai propaganda.

Bain & Co. published a recent report analyzing 123 large-scale outbound M&A deals in Japan between 1990 and 2014 (about five deals per year) and concluded that the Japanese were inferior at conducting M&A compared to other developed nations based on the frequency of subsequent impairment charges in their sample. And the number one reason they claimed was a lack of expert skill and experience: "First, there's the experience factor." Legal experts have voiced similar concerns: "It is quite rare that a Japanese acquirer has a team specialized in cross-border M&A. On the other hand, most foreign companies have their own M&A transaction teams composed of M&A legal experts, IP experts, accounting experts, IT experts, and labor experts." The consensus seems to be that Japanese companies are lousy at M&A, don’t do enough of it, and that the country’s stock market could benefit from a healthy dose of 1980s Wall Street thinking.

Why isn’t more M&A happening? Experts argue that doing M&A in Japan is extremely difficult, particularly for foreigners. To test this hypothesis, we first looked at the close rate on deals in Japan versus the United States to understand whether announced deals are more or less likely to close in Japan than in the US.

Figure 2: US vs Japan M&A Quantum and Probability of Success

Source: Compustat. Announce rate is defined as % of announced M&A transactions divided by number of public firms per year; close rate is defined as closed transactions divided by announced transactions.

We found that the number of attempted M&A transactions relative to publicly listed firms in Japan is only about 7.5% (850/11,229) of the US's equivalent figure. But once a deal is announced, there appears to be almost no difference in close rates between the two countries. In both markets, participants seem to have equally priced in the probability of success before even deciding to make a bid. In the US, buyers just tried 9.3x as often.

What about structural and cultural factors, such as corporate cross-holdings and resistance to foreign buyers?

To test if cross-holdings were impeding Japanese M&A, we compared the float rate (a rough proxy for cross-holdings) of the public sellers in Japanese M&A transactions. The successfully closed transactions' average float rate was 64.1%, and canceled transactions' average rate was a relatively indistinguishable 61.4%, suggesting that crossholdings may have played less of a role in suppressing announced Japanese M&A than is traditionally thought (for comparison, the average public float in Japan is 63%).

To test if resistance to foreign buyers impeded Japanese M&A, we compared the closed and canceled rates for all announced deals (including bids and letters of intent) when the buyer was foreign or domestic.

Figure 3: Foreign vs Domestic Buyers Acquiring Japanese Companies

Source: Compustat. Buyer's nationality grouped into Japanese and Non-Japanese by geographic headquarters. Close rate defined as Figure 2. Cancel rate is defined as canceled deals divided by announced deals. Mixed-buyer transactions omitted.

Despite the common belief in higher close rates and lower cancel rates for locals, the data here did not seem to support this hypothesis, as foreigners closed 85% versus 74% for the Japanese. Japanese boards here seemed just as willing to accept an overpriced bid whether it came in Yen from a local or was converted to the same-colored Yen by a foreigner.

We're left without much supporting evidence for some of the more popular explanatory theories for why the Japanese have been so much more conservative with M&A in recent history. So we turned to trying to understand the results of M&A in Japan versus the United States. If the advocates for M&A were correct, we’d expect to see companies that perform M&A deals outperforming the market—and to see all the expert advice and experience in the US translate to much greater outperformance than in Japan, where transactions are rare and MBAs struggle for respect.

We created a database of every M&A transaction by a public company in the US and Japan since 2000. We then compared Japan’s results to the results in the country that created junk bonds, hostile takeovers, and made icons of corporate raiders. We divided these transactions into deciles based on how much the deal increased the assets of the buying firm and looked at equity returns over the year following the transactions.

Figure 4: US vs Japanese M&A Premium to Buyer

Source: Compustat. Dataset of all 268,350 M&A transactions (including failed and closed) conducted by US companies (both public and private) between 2000 and 2021. 59,006 transactions were for publicly traded buyers. We applied the same method for Japanese M&As, with 7,922 publicly traded buyers (2000-2021). Premium is relative to the MSCI USA Mid Cap Index, as the median buyer's size was $2.7B and the MSCI Japan Small Cap Index as Japan’s median buyer was $700M. Delistings through the subsequent year occurred for ~5% of samples in the US and did not meaningfully skew the general results above when excluded or accounted for differently. Asset growth was overall lower for Japanese companies, where the median asset growth for the 10th decile was 96%. All-cash transactions (roughly half) were preferable to other forms of M&A in both geographies.

We found that corporate acquirers in the US generally tended to underperform the market. And the bigger the deal, the worse the returns. The firms in the 10th decile generated a -23% premium relative to the market in the subsequent year. In Japan, corporate acquirers tended to outperform the market, with little correlation between the size of deal and future returns.

Contrary to expert wisdom, Japan’s CEOs appear to have shown aggregate skill and efficiency in determining the right amount and scale of deal-chasing they engaged in over this period. And transformative Milken-style M&A doesn’t seem to have served US companies particularly well.

Japanese CEOs may have watched Wolf of Wall Street in theaters, but they seem to have chosen not to adopt the same corporate practices. Perhaps this is understandable in a country where most every CEO over 30 lived through the catastrophic economic consequences of a decade-long debt- and valuation-fueled asset bubble on a scale no Americans have ever experienced in their lifetimes.

Going forward, M&A may indeed pickup. For 20 years, corporate cash balances in Japan have gone up and valuations have gone down. While in the US, the opposite has occurred. The Japanese have a relative hoard of corporate "dry powder" compared to US corporations. And they are fishing in a local pond of publicly listed stocks that has almost doubled in number over 20 years, where in the US the number has been nearly cut in half (at least until the post-COVID SPAC and IPO boom began). More selection opportunities, at cheaper prices, and more dormant capital earning 0% on the balance sheet in theory should incentivize CEOs to find some positive NPV transactions. This may be a tailwind for Japan’s stocks at a time when foreign investors remain significantly underweight Japan through 2021. Indeed, one might say that the extent of most investors’ Asia exposure in 2021 was testing positive for COVID or experiencing the 22% drop in the MSCI China Index last year.

But the pace of change on the cultural front has historically been more glacial than many market enthusiasts have repeatedly hoped for. We've found in our research that Japanese corporate management has been systematically overly pessimistic about the future business environment since the late 80s, according to the survey data.

And to "get to yes" more often in M&A transactions, it helps if the buyers have a lot less humility and a lot more overconfidence in their abilities. For US M&A, this is not a novel speculation. Researchers have repeatedly found that indicators of hubris in individual acquiring CEOs (ranging from trailing short-term stock performance, to positive media publicity, to a lack of diversification in personal investments) seemed to be directly correlated with abnormal negative returns to the buying CEO's stock post-M&A.

Perhaps this reinforces the importance of the theoretical foundations of factors and verification of their continued persistence in addition to historical pattern recognition. According to our research, aggressive M&A is the single largest contributor to asset growth in the 10th decile of the famed “investment factor” (asset growth) in Fama’s 5-factor model, with 10th-decile firms engaged in M&A worth 52% of their individual firm’s prior year asset bases on average. It can matter looking backward and forward if we are betting against "just asset growth" or an indicator of CEO hubris in one culture. The former indicator won't really change, but the latter may vanish or unexpectedly reverse hard after long periods at certain points in history.

There may be a lot we can learn from the curious case of Japan's empire builders. Japanese companies both do far less M&A than US firms and seem to have had better results from the deals they do. Yet strangely, it is American consultants, bankers, and lawyers who believe their methods of doing business are superior, not the other way around.

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Credit: Educated in the US, Japan, and France, Taiki Morita is pursuing his MBA at Stanford and has been interning at Verdad since last October. Inspired by Dan and Nick, he hopes to work at a hedge fund next year upon graduation and find more contrarian intellectuals like himself.