Hedge Funds Will Be Collateral Damage in Japan

(Bloomberg Opinion) -- So long, activists. No one’s giving you any cash back, at least not anytime soon.

Companies and investors alike are stashing money as Covid-19 throws an uncertain future across the global economy. Liquidity is front of mind. Automakers and retailers in the U.S. have drawn down billions of dollars on their credit lines to deal with impending shortages. But Japan Inc. has an opportunity — to show hedge funds that have criticized serial cash hoarding and ineffective use of balance sheets that it’s had a point.

Piles of idle funds made Japan’s companies a target for global activists, including Paul Singer’s Elliott Management Corp. and Dan Loeb’s Third Point LLC. Tokyo’s stock market has become their highest priority outside the U.S. At the end of last year, activists held 3.4 trillion yen ($31.1 billion) of Japanese stock, doubled from the start of a state-led push for corporate governance reform in 2015.

Now, cash on the books looks like a strategic asset rather than a drag. When this crisis ends, there will be great need for capital. Prime Minister Shinzo Abe is incentivizing companies to retool supply chains away from China, the nerve center of world manufacturing. The likes of electronics giant Panasonic Corp. and auto-parts maker Aisin Seiki Co. say they’re looking at options.

Setting up new factories and logistics operations doesn’t happen without significant investment. Meanwhile, Japan’s perennial labor shortages, worsened by the pandemic, will mean more expenditure toward machines and automation. Inorganic growth via mergers and acquisitions will be on the back burner until losses are covered. Capital may also be redirected toward virus-related relief, such as producing ventilators.  

So far, a big portion of Japan Inc.’s cash has been put toward capital expenditure and research and development, with much smaller though increasing amounts for dividends and buybacks. Total payout ratios relative to operating cash flows are near 20%, compared to 60% in the U.S. Around half of non-financial companies have more liquidity than interest-bearing debt, versus closer to one-fifth in America or Europe. Only activist pressure has slowly shifted companies that far.

Hoarding is rooted in previous crises. Japanese companies, which typically rely less on external financing, have a chronic desire for cushions to survive cycles in an economy that’s always verging on a dip in growth. After the global financial crisis and the 2011 earthquake and tsunami, they resumed building balances to far higher levels than in other developed countries.

So activists zeroed in. Cash used for growth and returns as a portion of shareholder equity was around 20.5% as of last year, below the post-financial crisis average. Different companies hold their piles for varying reasons: small ones as a precaution; blue chips tend to want to invest more. Either seems like a win in the era of the coronavirus.

Sure, there’s a valid case for shaking up corporate governance and returning cash to shareholders. Since the government’s stewardship code emboldened investors, Japan’s business culture has seen the trappings of change, with more independent directors having a stronger role. Companies with higher dividends have been proven to outperform. It’s helped shake off the cozy relationships between big banks and management.

But even before the virus, resistance was building and a new law hindered foreign investors and activism. Covid-19 may further take the shine off the reform era. A recent study showed that hedge-fund activism often turns out to be short term, eventually reducing operating cash flow and investment spending. That’s the last thing post-pandemic business needs.

This isn’t to say companies won’t use the virus to bury unpleasant news; there’s always room for bad behavior and opportunism. However, there is a need to redo the math on what makes sense and reassess capital efficiency against safety cushions.

Activists may not be able to rely on pre-Covid-19 justifications, according to Keith Gottfried and Sean Donahue of Morgan, Lewis & Bockius LLP. There are just far too many uncertainties from the damage to supply chains, operations and the labor force. Rising environment, social and governance-based considerations will hold back institutional investors from banding together behind proxy fights: The coronavirus is, after all, a material social risk as applied to health, safety and human capital.

In this environment, some hedge funds may try even harder to justify the need for change, as Gottfried and Donahue point out. But beware of corporate raiders in the guise of white knights. For companies and their shareholders, cash piles will prove to be much safer.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Anjani Trivedi is a Bloomberg Opinion columnist covering industrial companies in Asia. She previously worked for the Wall Street Journal.

©2020 Bloomberg L.P.

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