Simon Fraser University at Harbour Centre

"Networking in Japan: the Case of Keiretsu"

Summary by Mackie Chase and Richard Wright

To understand the remarkable strength and success of Japanese companies today, it is necessary to examine the functions of the "keiretsu", or business group, and its impact on the present and future strength of Japanese firms. In his talk to the Forum, Dr Richard Wright described: the nature of the keiretsu; the mechanisms which integrate the affiliated companies within each major group; the key role of the major bank which operates at the core of each group; and the consequences for Canadian investors, business partners, and competitors.

KEIRETSU BACKGROUND AND CHARACTERISTICS

Before World War II several large industrial groups dominated Japanese economic activity. They were centrally owned and controlled with common interlocking directorships. After the war the United States forced Japan to dissolve these groups as they contravened anti- monopoly and anti-combine regulations. Since that time a number of major groups, or keiretsu, have reformed. Today each group is clustered together in voluntary association with a central bank at the core. An example of these powerfully related companies is the Mitsui Group, vying with Mitsubishi as one of the two largest keiretsu. Mitsui is representative of the key characteristics in these associations:

*Industry Range - The companies in the cluster are drawn from every industrial sector -- foods chemicals, metals, pulp and paper, finance, insurance, automobiles, etc.

*Ostensible Independence of Member Companies - Each company has its separate owners, shareholders, and board of directors.

*Central Role of a Major Bank - A major Japanese commercial bank is at the core of the group. The Mitsui Bank is at the centre of the web of approximately sixty companies with the Mitsui Trading Company and the Mitsui Real Estate Company also holding key positions.

*Nebulous Definition of Membership - There is no clear definition of members and non-members. Twenty or thirty members are very close and others are more loosely affiliated.

*Dynamic Nature of Relationships - The relationships of individual companies within the group can change with different degrees of affiliation. Toyota was traditionally closely associated with Mitsui but now has cash balances of more than twelve billion dollars, is loaning money to banks, and is establishing its own group of companies. Mitsui Bank would view Toyota and Toshiba, with a similar relationship, as continuing to be very honored members of the group.

THE INTEGRATING MECHANISMS OF THE KEIRETSU

When examining the Mitsui Group as a typical keiretsu cluster to determine just what holds its affiliated companies together, four mechanisms emerge: cross-shareholding, commercial transactions, personnel movement, and strategic coordination:

*Cross Ownership of Shares - Each company is likely to own small amounts of the shares of many of the other companies. A bank may own up to 5% and the other affiliated firms can also own share portfolios. In all cases, controlling shares are held "within the family" and are held for a long term. Shares actively traded on the stock exchange are limited to 20% to 40%. What happens to prices on the stock exchange is of little consequence as the majority of shares are held firmly and securely by other inside members.

*Commercial Transactions - Most borrowing is through the Mitsui Bank. As much as fifty percent of sales volume within the family of firms is to others in the same group. Companies purchase supplies, raw materials, and equipment from each other.

*Movement of Personnel - Cross movement of personnel, particularly senior personnel, makes it possible to transfer expertise when member firms move into new areas of operation. If a firm must phase out a product, staff can be absorbed into other firms. Certain technical people get together on a regular basis.

*Strategic Coordination - The CEOs of the 25 most strategically important companies near the centre of Mitsui meet every second Thursday to plan and discuss their business strategies. They give assistance to each other when new products are launched or new markets are entered, and they are kept informed about projects which affect the whole group. Intercompany accounts can be stretched over a longer term to provide extra liquidity. In an informal sense all other firms in the group can subsidize a company in an important strategic position. The Mitsui Bank will compensate by charging slightly higher costs for financing to the other companies while the member in the strategic position receives abundant financing at a slightly preferred cost of capital.

THE COORDINATING ROLE OF BANKS

The role of the main bank which exists at the heart of each keiretsu is qualitatively different from the role of the commercial bank in Canada, the United States, or almost any European country where the bank lends money to a company in which it has no direct ownership, involvement, or commercial interaction. The Canadian bank's main concern is the security of its loan. In Japan the bank stands as a virtual guarantor of the long term liability of the companies within its own group, forming a long term supportive relationship that is rarely found in our own society.

*Bank Support - If a company gets into financial difficulty and cannot meet its interest and principle repayments the bank will allow deferment of repayment and will continue making new loans to that company. Even when a company is no longer financially viable, the bank does not foreclose, but engineers a merger to draw the ailing company under the wing of one or more of the other members in the family. Physical assets are then incorporated into other operations and human resources are absorbed within the other companies. If there are losses to creditors the main bank will ensure that all creditors are paid off in full and will absorb the losses itself. The opposite situation exists when a Japanese company does not belong to a keiretsu and has no main bank relationship. Then there is no obligation at all on the part of the Japanese bank. Japanese lenders are wary of lending to such a company and therefore the company looks to foreign banks for most of its financing. If Japanese bankers do not want to lend to a company it should be an obvious signal to beware as a Canadian investor.

*Bank Control - In return for long term security and support the bank at the centre of the keiretsu gets a great deal of control and influence. Traditionally many Japanese companies have been financed almost entirely by bank loans. The bank participates directly in corporate management decisions, and has implicit veto power.

JAPAN AND NORTH AMERICA: CONTRASTS IN MEANING OF FINANCIAL TERMS

*Reverse "Debt" and "Equity" and Reverse "Creditor" and "Shareholder" - Debt and equity have almost opposite meanings in Japan and North America. When trying to understand the financial structure of a traditional large Japanese company, it is misleading to examine the balance sheet from a North American point of view because the sheet indicates that the company has very little equity and a large percentage of debt, with 70% to 90% of borrowed capital in short term bank loans. A more realistic picture can be achieved by examining the balance sheet with the terms "equity" and "debt" reversed. Then the financial structure appears very similar to that of a typical North American company, with the position of the Japanese bank seen as equivalent to that of the position of the North American shareholder.

*Bank as Risk Taker - In Japan the main bank at the centre of the group, the creditor, supplies most of the financing in the form of short term loans which are rolled over perpetually. Although the loans have fixed nominal rates of interest, the companies that borrow must keep substantial compensating balances on deposit at the bank. If the company does well, the balances get larger; if poorly, the balances can be drawn down to zero or negative. Therefore the real return to the bank fluctuates directly with the earnings of the company. The bank participates directly in the management decisions of the company and absorbs a great deal of the risk.

*Shareholder as Creditor - In Japan the shareholder has a very secure position. The shareholder supplies only a small proportion of the financing and has a virtually no direct role in the management of the company. Dividends are usually based as a fixed percentage of the par issuing value of the stock and do not fluctuate with earnings.

CONSEQUENCES FOR INVESTORS

Understanding the group relationships within the keiretsu makes it is possible for the foreign investor to make sense of Japanese price/earnings and market value/book value ratios. Investors in large Japanese companies are really investing in a closed end mutual fund:

Ratio                                US                 Japan 
Price/Earnings                       7.8x               40 to 50x 
Market Value/Book Value              129%               500 to 700% 
 

The Japanese figures appear bizarre when forty to fifty years are required to recover an investment. However, investment in a Japanese company actually means investment in the holdings of all the companies that function cooperatively in the keiretsu. The holdings and shares of these companies are recorded at their value at the time of purchase, a fraction of what these values may be today. Real estate holdings, for example, are listed at historical book value and may be worth hundreds of times that today. Investment in a Japanese company cannot be seen in terms of projecting current cash flows from the main operations of that company, but should be seen instead as a set of holdings in a diversified mutual fund with enormous amounts of hidden assets scattered throughout the whole network of companies.

CONSEQUENCES FOR BUSINESS PARTNERS

A Canadian company seeking to do business with a Japanese company in any long term contractual relationship or joint venture relationship should beware of the powerful advantages the Japanese business has through its system of intercompany coordination. The Canadian firm must not assume that the Japanese company wants to maximize profitability. As part of a keiretsu, profits can be siphoned off to assist other companies in the group. Profits that show up in a joint venture company must be shared with the foreign partner, whereas profits drained off through charges for financing, purchase of materials, or distribution can be kept 100% within the "family".

CONSEQUENCES FOR COMPETITORS

Group linkages give enormous competitive strength which our own stand-alone firms would find almost impossible to duplicate. Important advantages for companies within a keiretsu include:

*Secure Financial Base - There is no threat from external takeover bids.

*Low Cost Financial Structure - There is lender monitoring and this quality of information translates to 1% lower cost of capital.

*Economic Diversification - Companies can undertake risky investment to develop new product lines with other keiretsu members providing subsidies, technological know-how, as well as captive markets.

*Fadeout Ability - Within the keiretsu there are great advantages when winding down inefficient operations. Resources can be freed up for new activities and human resources shifted to other companies with no overt bankruptcy or layoffs.

*Access to Technology - If Toshiba develops new technology for global communication or trading rooms, Mitsui Bank has immediate proprietary access, whereas in Canada banks must go out and shop for new technology on the open market.

*Economies of Scope - The keiretsu have the ability to link together different products and services while enabling each individual company to specialize in what it does best.

*Stable Internal Management Relationships - Employees can expect lifetime security. Their own long term objectives coincide with those of the company. These stable internal relationships are predicated largely on the stable external environment provided by the keiretsu group.

*Long-Term Planning and Profit Horizons - Japanese companies can engage in price competition for an extended time without generating profit until they eventually gain a desired market share. Strategically important companies can depend on the long-term support of related creditors, shareholders, suppliers and customers.

CHANGES IN THE STRUCTURE OF JAPANESE COMPANIES TODAY

Today the central role of the commercial bank is changing in terms of power and influence. Dependence on the bank is diminishing because many companies now have greater cash resources and credit ratings. Capital markets and equity markets are developing, and large companies are able to issue their own securities. Securities companies may take the place of the banks at the centre of industrial groups. Whether the bank or the securities company sits at the centre of Japanese keiretsu, the power of these groups is likely to remain for the long term, and to have profound consequences for Canadians.