Volatility is high in Japan’s public equity markets. The Nikkei 225 index lost 4,451 points on Monday, its largest single-day decline since 1987. The sell-off was sparked by a surprise interest rate hike by the Bank of Japan, which strengthened the value of the Yen thereby decreasing its attractiveness in carry trades (i.e. borrowing in Yen to invest in high-yield assets elsewhere). 

Japan has had negative interest rates since 2016, making the Yen one of the most popular carry trades in foreign exchange markets. It’s also what has made the country a rare bright spot for PE buyout activity over the past several years, with KKR’s Scott Nuttall calling it the “most interesting” market for traditional buyouts earlier this year. Firms such as KKR, Bain Capital, Carlyle Group, and Blackstone all have dedicated Japan-focused funds or significant investments in Japanese companies. Collectively, buyout firms invested nearly $40 billion in Japan in 2023, up 48% year-over-year, according to data from Mergermarket.

But the party can’t go on forever – and the Bank of Japan may have just turned the lights on.  

Negative sentiment

First and foremost, higher interest rates can slow down economic growth. If Japan’s economic outlook deteriorates, it could impact the performance of portfolio companies, leading to lower revenues and profitability. This affects the ability of private equity firms to generate returns.

This could, in turn, damper the excitement that investors feel for Japan, leading to a reduction in investment flows into Japanese assets, including private equity investments. Lower capital inflows can reduce liquidity and increase competition for quality deals.

Negative market sentiment has already led to a significant sell-off in public equity markets, like the Nikkei 225 – and this can spill over into private markets. Negative market sentiment can lead to valuation discounts, affecting existing portfolio companies and making it more challenging to exit investments at favorable valuations. On the exit front, public market volatility can also reduce the likelihood of successful IPOs, and strategic buyers may be less willing to engage in M&A activity at attractive valuations.

Portfolio pressures

At the portco level, the cost of borrowing has increased for companies in Japan. This can lead to higher financing costs for private equity firms, straining the financial health of portfolio companies, especially those with significant debt on their balance sheets, and impacting companies’ ability to invest in growth and expansion initiatives. 

The strengthening of the Yen can also lead to increased currency volatility. Private equity firms with investments in Japan may face exchange rate risks, impacting the value of their foreign-denominated assets and liabilities. Hedging these risks can add to the cost and complexity of managing investments.

The unwinding of the Yen carry trade

Finally, LPs in private equity funds might demand redemptions to free up cash to cover losses if they had exposure to the Yen carry trade. This would put further pressure on PE firms to exit portfolio companies – even if it means doing so at depressed valuations.

While the unwinding of the Yen carry trade poses direct risks to the Japanese market and private equity investments in Japan, it also has the potential to create ripple effects across global private equity markets. Investors exiting positions to cover losses can lead to liquidity issues, forced sales, increased redemption requests, and negative market sentiment, all of which can compound the challenges faced by private equity firms in managing their portfolios and achieving desired returns.