Qualified once, supplied for a decade: specialty materials in Japan

Japan holds the firm's specialty-materials relationships because the qualification cycle there is longer than in any other market the firm covers, and the reward for surviving it is longer too. A high-purity material sold into semiconductor, medical device or aerospace production is qualified by the customer rather than by a supervisory authority. Qualification runs three to five years and costs the customer more than the material does. Once complete, the supplier is written into a specification the customer will not reopen without cause. The Tokyo office opened in the first quarter of 2024 to sit closer to those specifications.

The opportunity is ownership rather than growth. Many of these producers are family-held, in their second or third generation, with 40 to 120 employees and a single site. Succession is the pressure. The founder's children do not always want the business, and a domestic trade sale usually means absorption by a larger group and the quiet loss of the specification. The firm takes minority positions of 20 to 30 per cent with a board observer seat, a capital commitment for plant renewal, and no change to operating management. Four such conversations were live at July 2024. Two positions were held.

Diligence starts with the specification file, not the accounts. The firm reads the customer qualification documents, the change-control history and the record of deviations, because a supplier that has altered a process without notifying its customer holds a liability rather than a franchise. It then reads the customer contracts for termination for convenience and for volume commitment. A specification is worth what the contract behind it obliges. In the two positions held, contracted volume covers 61 per cent and 44 per cent of capacity, with the balance sold on rolling annual orders.

Customer concentration is the standing risk. A producer with one qualified customer taking 70 per cent of output has a single point of failure that no covenant repairs. The firm underwrites to a ceiling: no position where a single customer exceeds 55 per cent of revenue at entry, and a funded plan to qualify a second customer within three years. Qualifying that second customer costs between US$1.5 million and US$4 million in trial material, engineering time and yield loss. That cost is the investment case, and it is the reason the capital is wanted at all.

Structure follows the currency of the cash flow. Positions are held in yen through the Japanese entity and funded from the regional treasury in Singapore. The firm does not hedge the equity value of a position it expects to hold for seven years. It hedges the committed capital between commitment and drawdown, and the expected proceeds inside twelve months of a signed sale. Sumida Information Systems supplies the pricing and specification data used in monitoring, on the terms the Third-Party Risk and Outsourcing policy requires of every vendor.

Exits are to strategic buyers who need the specification. The firm has modelled a holding period of six to nine years, longer than in any other origination sector it works in. That length is the point. A qualification that took five years to win does not lose its value in a downturn, because a customer cannot switch faster than it qualified. Capital that can wait earns the difference between a cyclical multiple and a structural one. Very little of the firm's capital can wait that long, which is why the Japanese book is capped at US$60 million.

Published 2024-07-16 by the Private Equity division. Research is prepared for eligible counterparties and does not constitute advice.