Guest contribution: Toshiba and the hidden costs of activism

Global value investor Andrew McDermott asks an important question: can the activist campaign against Toshiba really be called a success?

At Japan Optimist, I aim to present the real forces shaping Japan, so I want to expand horizons and give real-world practitioners with “skin-in-the-game” a platform to present their case. Particularly when it comes to corporate governance issues, giving concrete corporate examples and case studies is often a much better way to gain insights into how Japan actually works than the standard general narrative offered by most. Japan excels in the particular….and yes, the case of Toshiba deserves much greater study and attention.

Never before had a boardroom battle been this long and drawn out. Given Toshiba’s historic dominance in Japan -it was the industrial backbone of the Mitsui Keiretsu- practically all dimensions of Japan’s political, financial, national security and social economy got involved. Yet it is by no means clear that Toshiba marks a victory for US-style capitalism in general, shareholder & PE activism in particular.

Simply put: an investment in Toshiba’s peers -Hitachi, Sony, Fujitsu- more or less consistently outperformed Toshiba’s shares since the start of the campaign. Specifically, Toshiba’s shares rose 76% while Hitachi’s rose 147% (Nov 2017 to Dec 2023). Of course, share price isn’t everything, so please see, following Andrew’s article, an addendum that aims to quantify some of Toshiba’s corporate (under)-performance and lost opportunity as Toshiba’s executives were distracted by the fight against global activists.

The author is a friend and fellow investor/activist/strategist, Andrew McDermott. He has been involved with Japan since he joined NEC Logistics in Tokyo in 1992. After moving on to JP Morgan investment banking, Andrew set up his own investment management business, Mission Value Partners, in 2010 (see full bio below). He has been involved in more than 60 or so activist campaigns in the US, Europe and Japan. Although he has a global mandate for his fund, he is currently 100% invested in Japan. The opinions expressed here are his own and in no way are intended as investment advise. Also, I am not invested in his fund.

Enjoy and as always, comments welcome. Many cheers from cold & rainy Tokyo ;-j

Toshiba and the hidden costs of activism

As the calendar turns to 2024, Toshiba has disappeared with a whimper in a $14bln deal that won the dubious distinction of topping the league tables in a "bad vintage" for private equity ("PE"). Toshiba represented "The Test Case for Corporate Governance in Japan" (Asia Fund Managers). If, as the Financial Times argued, "The Toshiba showdown could be a turning point for Japan Inc's fortunes," it was also billed as a turning point for activist investors who, according to the Wall Street Journal, "finally [got] a seat at the table." Equally, Toshiba was supposed to provide an opportunity for bulge-bracket US private equity firm Bain to demonstrate what it could teach Japanese managers. Bain promised to introduce US-style management to Toshiba's valuable semiconductor business, which it acquired as part of the leveraged recapitalization organized by Goldman Sachs during the 2017-2018 Westinghouse crisis. Bain expected the rest of the Toshiba business to follow the memory business into PE hands.

After six years, the test results are (mostly) in. How did everyone do? The point of this piece is not to rehash the history of Toshiba (for those interested, a serviceable timeline appears here). Rather, the point is to judge the protagonists by their results and to see what, if any, lessons can be learned that apply to future deals.

Toshiba provided the first full-scale test of "PE-activism" in Japan. The tactics were simple: gain control of the board as quickly as possible using as little capital as possible, then ensure that the board would auction the business in whole or in part to private equity buyers. In the meantime, exploit regulatory loopholes to run the public company as if it were already in the hands of private equity managers. The tactics ultimately succeeded. The activist investors, principally Effisimo, 3D, Farallon and, later, Elliott, placed six friendly directors on the board who shared a commitment to breaking up the company. They also succeeded in expelling Chairman Osamu Nagayama (with an assist from the Harvard endowment) and forcing the resignations of both Mariko Watahiki and George Olcott. None of these directors had anything to do with the problems of prior management. Mr. Olcott, whom I know from prior campaigns, and Mr. Nagayama, who had deep experience leading the restructuring of Chugai and Sony, were eliminated almost immediately. Ms. Watahiki's rearguard defense collapsed in 2022, paving the way for the final auction. While taking control of the board, the activists worked hand-in-hand with Bain and other PE firms to "pre-sell" Toshiba. By the time the last non-activist director had been purged, a private equity auction had become the only viable option for the board.

Presumably, this deal has been a success in the eyes of the principals. The activists all exited with a profit, though, ironically, the highest bidder was a "throw-back" consortium backed by the Japanese government and a number of Toshiba's corporate partners. Bain's co-CEO Steve Pagliuca told the Davos crowd that the Toshiba deal was "great" and that Japan had become a country where Bain could act the same way it does everywhere else in the world. Considering that Bain took most of its money off the table within months of investing, Bain probably has already pocketed a decent return alongside hefty "management and advisory fees" that will make Toshiba profitable for Bain's investors regardless of the ultimate fate of the business.

But before popping the champagne and reloading for the next PE-activist corporate takedown in Japan, it seems worth pondering a few questions.

• What if, instead of immediately re-leveraging the company through buybacks (at the Toshiba level) and capital returns (at the Memory business now called "Kioxia"), Toshiba had invested the capital raised in its actual operations as Hitachi and Intel (under its original managers) had done at similar critical moments in their corporate histories?

• What if the new investors had followed the lead of other restructuring Japanese companies and supported the promotion of an engineer with experience in the business rather than hiring CEO Nobuaki Kuromatani, a former banker whose primary qualification seemed to be his connection with CVC, a putative PE bidder?

• What if, instead of hiring outside directors who specialized exclusively in finance and had little stake (financial or otherwise) in Toshiba, the company had cultivated a mix of international directors with experience in rebuilding, rather than liquidating, companies?

• What if Bain had actually brought operating expertise to Kioxia rather than hiring Stacey Smith, a finance pro responsible for what Charlie Munger called "the failure of Intel" due to its decision to prioritize financial engineering and management compensation over technical innovation?

• What impact did Bain's multiple (and continuing) attempts to exit Kioxia via IPO or merger have on its capital spending, R&D budget or employee retention?

• What if the eventual 2023 buyers of Toshiba had simply recapitalized Toshiba in the public market back in 2018 and pushed through their own management changes? Would their choices have been any better than those dictated by a group of activists and private equity leaders whose sole lifetime experience was in arranging financial transactions and preparing powerpoint presentations?

It is of course impossible to prove a counterfactual, but a few facts are worth noting:

1. Brookfield purchased Toshiba's US nuclear business out of bankruptcy for $1 billion, or $4.6billion including assumed debt. The core of this business was the profitable and strategic nuclear services business recently purchased by Cameco for $7.9 billion. Toshiba could have easily participated in this recapitalization had it put aside 20% of the capital raised in 2018 rather than immediately using it for share repurchases. Cameco's share price speaks to the value of such a move.

2. Toshiba Memory/Kioxia has been absent from most of the developments in advanced memory over the past few years. Toshiba invented NAND memory and was considered a technical leader for decades. The CEO when Bain took over was Dr. Yasuo Naruke, an experienced technologist with deep manufacturing experience who realized that technical leadership required investing through the cycle in both people and capital equipment. Today, after six years under Bain's control and Dr. Naruke's untimely death, Kioxia has 0% marketshare in high-bandwidth memory, a category essential for AI and dominated by former peers SK Hynix, Samsung and Micron (as reflected in their multiples and share prices).

3. Kioxia has played a minor role in the explosion of semiconductor investment in Japan that has accompanied rising trade tensions with China. It is Micron that will bring the most advanced memory chip technology to Japan. TSMC, IBM, Samsung and others are all paying premium wages to attract scarce engineers as Kioxia struggles to find a partner willing to recommit the capital that Bain has already extracted.

4. As The Japan Optimist has noted, the operating performance of companies managed by "plain old Japanese executives" has quietly outdistanced global competitors even before accounting for the impact of exchange-wide encouragement for better governance. ( see In praise of the Salaryman CEO ).

None of the above possibilities excuse the mistakes made by Toshiba's prior management, regulators, or bankers. However, they are worth pondering as we contemplate the New Year. There is no guarantee that Toshiba would have done better absent pressure from Effisimo, Bain, et. al. However, there are dozens of Japanese companies who have quietly reformed themselves without the costs incurred by Toshiba. These companies were led by a new generation of corporate leaders with experience, skin in the game, and external support from the GPIF and PFA. These Japanese institutional investors have demonstrated the utility of activism as a tactic, rather than a strategy, of stewardship. In the process, they have nurtured a crop of local managers who have passed the tests of experienced investors and observers as disparate as Warren Buffett, Wilbur Ross and Clyde Prestowitz.

US private equity strategies face serious questions from within and outside the industry even as public US companies such as Boeing founder under leaders who cut their teeth in PE roles. Japanese companies increasingly fill urgent gaps in America's industrial and defense supply chains created by decades of "asset-lite," finance-first management.

It seems worth pondering the lessons of Toshiba in the US as well as Japan, particularly as we consider the opportunity offered by inbound M&A such as the Nippon Steel/US Steel deal. Could the Japanese salaryman CEO ultimately rescue the US financial engineers rather than the other way around? If so, could the right investment approach to Japan be that espoused by Warren Buffett and the GPIF rather than that of Effisimo, Bain and Harvard?

Brenden Ballue, in Plunder: Private Equity's Plan to Pillage America, argues that: "When forced to actually run businesses, private equity firms often show surprising ineptitude. Their executives' talents often come not from operating the levers of businesses, but from the levers of power: securing financing, identifying regulatory holes, and creating them when they don't exist." Japan provides a laboratory in which to test Mr. Ballue's thesis because so many of Toshiba's Japanese peers have restructured successfully without the help of "PE-activisits." What do the "Toshiba test" results imply for investors contemplating a sudden need to underwrite real things that work rather than simply manufacture investment returns?

The opinions expressed are my own. They are not intended as investment advice. I currently own and may in the future own positions in securities mentioned in this article. Andrew McDermott - Nashville January 9, 2024

For Andrew’s bio and more of his thoughts, please see his previous guest contribution to Japan Optimist Why not Hitachi?

Addendum to "Toshiba and the hidden cost of activism": a look at the Numbers

Total share price return : Nov 18 2017 —> Dec 19 2023

Toshiba: 76%

Hitachi: 147%

Sony: 158%

Fujitsu: 168%

TOPIX: 47%

Operating Income, Yen billions: Year ending Mar 2018 —> Mar 2023

Toshiba: 25 —> 93

Hitachi: 714 —> 942

Sony: 739 —> 964

Fujitsu: 162 —> 222

*The 2023 number includes Toshiba’s 40% share of Kioxia’s y191bn operating loss.
Toshiba planned 2023 Operating Income announced in 2018 was y320bn excluding Kioxia

Toshiba raised 600billion yen in December of 2017. Using Bloomberg numbers, Toshiba's market capitalization on the day of the 2017 capital raise was 1.3trillion. Six years later, the equity sold for 1.9trillion. There are lots of capital changes that make it difficult to calculate how capital flowed, but let's just say for the sake of argument that the increase in valuation was purely a result of the PE/Activist value-add as opposed to simply reflecting a return on additional capital employed. This is a reasonable assumption because the capital invested by the PE-activists was almost immediately extracted from Toshiba via a series of public and private market transactions that effectively created a leveraged re-capitalization of the entire entity by borrowing against the semiconductor business. Why the banks did not simply do this without these financial engineering transactions is a subject for another day.

The question before the court is: "what might have happened if the 600bln had been raised from shareholders who had left their capital inside the company and picked operating managers to deploy this capital in areas where Toshiba had a demonstrated engineering or technical edge." As boring as this sounds, this was precisely the strategy followed by all of Toshiba's local competitors.

The most logical businesses for Toshiba to invest fresh capital were the international nuclear business that ultimately went to Cameco after recapitalization in bankruptcy and the semiconductor memory business. Let's cross-check this a couple of ways.

If the 600bln had compounded at 10% per year, then it would have been worth 1.0T at the end of six years. Toshiba's equity capitalization at buyout in 2023 was 1.9T. Adding 1.0T to this number would be a meaningful improvement. Of course, the share count would have been higher, but let's continue the thought experiment. Let's assume that 100bln went to the nuclear business that was ultimately sold to Cameco and the balance went to the semiconductor business and was used to keep pace with SK Hynix in high-bandwidth memory.

We know that the nuclear business was sold at a 100% return on the enterprise value of the company, or a 3-4x return on the equity value. That would mean that the 100bln put into nuclear would be worth 300-400bln now. The semi business is harder to value because the volatility in operating results has been trumped by excitement over the HBM business. Thus, even though SKHynix has recently lost money just like ToshibaMemory/Kioxia, the equity market has rewarded SKHynix to the tune of a doubling in market cap and a 2.5x multiple of enterprise value since December of 2017. SKHynix currently attracts a revenue multiple of 4.0x compared with the 2x multiple afforded Western Digital, the closest comp to Kioxia in more ways than one (Western Digital is also levered, also beset by activists, and also woefully behind better capitalized competitors in HBM. It is Bain's merger partner of choice for Kioxia).

Again, it is hard to be precise, but it is fair to say that a successful deployment of 500bln into a high-bandwidth memory project comparable with SK or Samsung would be worth at least double the capital employed. So, in this theoretical exercise, it's possible to see how 600bln

invested in the Toshiba business could be worth 1.3-1.4bln now by simply executing at peer level for six years. Taking the midpoint and discounting six years implies a 14% return on invested capital. Is this too high for a perennially low return Japanese market? Perhaps, but it also bears an uncanny resemblance to the total returns earned by a subset of Toshiba's Japanese competitors over the past six years in the stock market, returns that, in almost all cases, have handily outdistanced the start to finish returns earned by Toshiba during its activist reign. In addition, those competitors' shareholders have been able to stay in place for the recent uplift in Japanese equities without incurring capital gains taxes, lockups,"2 and 20" fee structures, or all the heartburn associated with a delisting.

The hidden costs of private equity activism seem to have been higher than advertised in the Toshiba case. We should at least examine the evidence with care before uncritically accepting a leading consulting firm’s recent contention that private equity is a "force for good" in Japan. It is certainly good for private equity firms and their activist helpers. The rest of us may prefer the slow and steady approach of the GPIF and TSE, whose prudent but creative activism has delivered enormous value with little fuss and lower fees.