Giving Japan A Workout

U.S. investors are leading the charge with record purchases of distressed assets

When Jack Rodman first began visiting Tokyo in the early 1990s, he saw it as a gold mine for restructuring and buyout deals. After all, Japan's big banks were saddled with trillions of yen in bad loans to real estate speculators and industrial clients who were beginning to suffer from what turned out to be a decade-long slump.

Someone had to wade into this mess and force the debtors to cough something up. Rodman, head of Ernst & Young's Asia Pacific Financial Solutions group and a veteran of the U.S. savings-and-loan debacle, was able and willing. Yet Japan's first sale of nonperforming loans didn't take place until 1997. And after an initial burst, they came in at a slow trickle. Rodman kept explaining to Japanese bank execs that the bad debts wouldn't go away by themselves, "but nobody would listen. No one was willing to accept that there was even a problem."

Today, the Japanese not only acknowledge the problem, they are welcoming workout honchos like Rodman with open arms. Investors, led by bulge-bracket investment banks and U.S.-based private-equity firms, are buying record amounts of distressed assets in Japan, working out debt payments and restructurings with thousands of companies.

According to Ernst & Young, so far this year foreign investors have spent $14 billion buying nonperforming Japanese assets, up from $7.3 billion in 2003. "Last year was our biggest year ever in terms of investing in Japan, but right now is the peak," says Chol-Ho Kim, an executive vice-president at GMAC Commercial Mortgage Japan in Tokyo, a branch of U.S. auto manufacturer General Motors Corp. (GM ), which has invested more than $1 billion in Japan's nonperforming loans. "The market is gushing with deals," says Kim.

That $14 billion also understates the impact of the gaijin. Considering that the workout firms pay a fraction of face value for these distressed assets, foreigners have acquired debts with a paper value approaching $100 billion in the past two years alone -- a significant portion of Japan's total burden of bad debt.


The creation of the debt workout industry in Japan is another sign that its economy is starting to change in ways no one would have predicted just a few years ago. Credit for the boom in distressed debt goes to Prime Minister Junichiro Koizumi. He decided last year that Japanese banks had to cut their nonperforming-loan ratios to 4.1% of assets by March, 2005 -- half the average ratio of bad loans the banks were then carrying. Heizo Takenaka, who is both Economy and Financial Services Minister, then threatened to prevent banks from padding capital bases with deferred tax assets unless they stepped up the pace. Suddenly, the phones started ringing off the hook at E&Y and other workout shops. "After Takenaka came in and took the bull by the horns, it opened up a wave of transactions," says Rodman.

Now the banks are even unloading the better-quality problem loans. When the first deals were hatched in the late 1990s, the only loans the banks were willing to shed were for real estate deals where the borrowers had long since stopped making payments. Those loans were sold for 5% or less of face value. Today, assets sold include the debt of companies still servicing at least some of their debts and are bringing as much as 25% of book value.

So instead of flipping these loans immediately, investors are acquiring equity stakes and taking an active management role to coax out more value. "Two years ago, all you saw was bankrupt borrowers," says Clark Graninger, head of the institutional-banking group at Shinsei Bank Ltd., the former Long-Term Credit Bank of Japan, itself a product of a big bankruptcy selloff, to the U.S.'s Ripplewood Holdings. "Loans coming on the market [now] are borrowers who've made some repayment," he adds. "So there are more strategies to pursue."

GMAC, for example, bought both the bad loans and an equity stake in a Nagoya-based real estate company six months ago. The company, which it refuses to name, got overextended in the early 1990s and has struggled with debt ever since. Once it got in the door, GMAC immediately began selling off noncore assets. The plan is to prepare it for resale within two years.

A long list of other foreign firms are doing likewise. Goldman Sachs Group Inc. (GS ) now owns two bankrupt golf course operators that control a total of 46 courses. In January, Texas-based Lone Star Group bought Holiday Tower, a failed operator of several landmark hotels, for $90 million.

Colony Capital, another U.S.-based private-equity investor, struck a $680 million deal in March for the debt-mired Sea Hawk Hotel & Resort and adjacent professional-baseball stadium in the southern Japanese city of Fukuoka, both owned by troubled retailer Daiei Inc. (DAIEY ). And Goldman Sachs invested $180 million last month in Kondo Sangyo Corp, a shaky Osaka-based condominium builder. The U.S. investors, wary of being labeled foreign "vultures," generally refuse to name the companies they are buying, or to divulge the profits they expect to make. But analysts say the typical return on the restructured assets that have already been sold is 20% to 30% a year.

The Japanese are jumping in, too. Last December, Pacific Management Corp., a property-management company, launched a $461 million fund to buy out real estate holdings of midsize Japanese corporate borrowers. Creed Corp., a real estate broker that did due diligence for foreigners, has started making proprietary investments in distressed property.

The active buying has done wonders for the Japanese banks. Two of Japan's megabanks -- Sumitomo Mitsui Financial Group Inc. and Mitsubishi Tokyo Financial Group (MTF ) -- have already met the government's new requirements months ahead of schedule. Others are expected to follow suit. Even troubled giant UFJ, which still had a bad loan ratio of 10.24% in March, is estimated to have disposed of $6.35 billion of loans during the six months to September. "Unless something very negative happens to the economy, the worst of the banks' problems are over now," says Yoshinobu Yamada, a bank analyst at Merrill Lynch & Co. (MER ) in Tokyo.

The next phase? Workout specialists expect a feast from the near-collapse of giant retailer Daiei, taken over on Oct. 13 by a state agency, the Industrial Revitalization Corp. of Japan. The IRCJ could sell off pieces of Daiei debt. Meanwhile, the foreign workout shops have begun to establish footholds in other areas. In August, GMAC raised $127 million securitizing real estate loans, its third such deal in 10 months. "The [nonperforming loans] market has really pried open Japan," says GMAC's Kim. About time.

By Ian Rowley in Tokyo

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