Global Business

Problems of the Pioneer

Orix has been hit by an insider scandal. Can it continue shaking up Japan's hidebound business culture?
David LineAugust 17, 2006

Most executives would blanch when a high-profile figure with whom their company has a close association is arrested on suspicion of insider trading. Shunsuke Takeda, CFO at Orix Corporation, Japan’s largest non-bank financial-services firm with revenues of 947.8 bn yen (US$8.13 bn), was no exception. Takeda says that the arrest in early June of Yoshiaki Murakami, a pioneering shareholder activist and Japanese business icon, was “a very large disappointment to us”, employing typical understatement: Orix shares fell as much as 12% in one morning when the scandal first broke. Orix had supplied 45% of Murakami’s startup capital and still has 20 bn yen invested in the aggressively run Murakami Fund.

Orix, which is perhaps more famous among Japanese in the street for owning a baseball team (Orix Buffaloes of Kobe and Osaka) than for its core leasing and finance businesses, suffered more adverse publicity when a subsidiary managing a real-estate investment trust, Orix JREIT, became the latest in a series of firms to fall foul of Japan’s increasingly activist corporate regulators. Japan’s Securities and Exchange Surveillance Commission (SESC) in mid-June asked the country’s Financial Services Agency (FSA) to impose administrative penalties on Orix JREIT and Orix Asset Management, after the former failed to make adequate assessments when purchasing property for the latter. Orix JREIT’s shares fell 7.4% on the news, resulting in the worst day in three years for the Tokyo Stock Exchange’s REIT index.

The irony is that maintaining a reputation for excellent corporate governance is at the heart of everything Orix does. Its unique history and ownership structure — with the highest proportion of foreign shareholders of any comparable Japanese company — have helped forge this reputation, as well as encouraged Orix to pursue growth strategies even as many Japanese companies have been focused on consolidation and downsizing. But it seems that, by diversifying rapidly into many different businesses and attempting to shake up Japan’s staid business culture, Orix has put its hard-won reputation on the line.

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Takeda might seem relatively sanguine about the impact of the Murakami issue, but others see it as big trouble. “The Murakami problem has had a big negative impact on Orix’s reputation,” says Shinichi Iimura, an analyst with Nomura Securities in Tokyo. On the face of it, there are two problems, Iimura says. The first is that Orix has 20 bn yen in the fund, which brings negative associations given Murakami’s admission that he benefited from insider information (albeit unwittingly, he claims). “The second point is that maybe there is a relationship between [Orix chairman and CEO Yoshihiko] Miyauchi and Murakami,” Iimura says, alluding to their reputed friendship. If there were a close connection, it could be embarrassing, especially as Miyauchi is president of the government-commissioned Council for the Promotion of Regulatory Reform.

Fighting Sclerosis

Orix is an atypical Japanese organization in many respects. For one, foreign investors own around 60% of its shares — a proportion Ryoji Yoshizawa, an analyst at Standard & Poor’s in Tokyo, describes as very high, estimating that a more common level for companies that boast a substantial portion of foreign equity investors runs between 30% and 40%. The high level of foreign holdings makes it certain that non-Japanese owners have strong influence over Orix’s corporate philosophy and strategies, and dictate its manner of response to shareholder demands and adherence to corporate-governance standards. In Japan’s frequently sclerotic and hidebound business culture, satisfying shareholders’ demands and ensuring a high degree of transparency and management accountability are not always dominant priorities.

Press excoriation of Murakami’s behavior, even before the scandal gave the media an easy reason to do so, has proved to be a kind of thermometer reflecting the degree of institutional hostility to corporate reform. Even the Nihon Keizai Shimbun, moderately progressive in its economic views, attacked Murakami for his aggressive pursuit of profit maximization, arguing, extraordinarily, that a “true professional” investor must realize that he “cannot win simply by arguing that a company belongs to its shareholders”.

As they were both, in their own way, seeking to reform Japanese business culture from within, it was inevitable that Murakami and Orix’s senior managers had goals in common, something Takeda readily confirms. “We had sympathy for Murakami’s original objective,” Takeda recalls. “That’s why we put up some seed money for his operations. We assisted Murakami when he started particularly because he had aspirations to improve corporate governance in Japan, and Orix is an advocate of promoting more effective corporate governance.” In February this year Orix opted to sell its capital stake in Murakami’s firm — doubtless as rumors began to swirl about connections between Murakami and Takafumi Horie, the maverick entrepreneur and chief of the internet investment firm Livedoor, who had been arrested in late January. But with 20 bn yen still invested in the Murakami Fund itself, the connection is closer than Takeda finds comfortable. The whole affair, Takeda rues, is an “unhappy incident” for the development of Japan’s corporate environment.

If the Murakami connection was embarrassing, being told off by the FSA was doubly so, given the importance Takeda and the firm assign to ensuring proper management controls and corporate governance standards. For once, Orix seems to have been caught out in securing its internal management structures. According to the SESC investigation, Orix Asset Management failed to ensure adequate due diligence before purchasing buildings for Orix JREIT. The SESC also said Orix JREIT hadn’t held 88 of the 130 board meetings it had claimed it would in the period from September 2001 to February 2006. In this, the subsidiary broke one of Takeda’s cardinal rules of management: to ensure compliance “particularly by developing internal controls”.

A Japanese Exemplar

Orix’s corporate governance has been well regarded when compared with other Japanese firms. Standard & Poor’s issues a “Corporate Governance Score” on the firms it rates, ranging from 1 (poor) to 10 (exemplary). Last July Orix’s score was raised from 7 to 8, with Orix described as “a leader among Japanese companies in adopting global best practices in corporate governance, even before shifting to a committee structure in 2003”. (Japan’s commercial code was revised in 2002 to promote the board-with-committees structure, but many large Japanese firms have yet to adopt it.)

Takeda is visibly proud of this track record. “This is a very good mark among other Japanese companies, [which] are notorious for having bad corporate governance,” Takeda asserts, speculating that on S&P’s system, the average score for Japanese companies is “around three or so”. Takeda has been determined to reinforce this within the company during his decade as CFO, particularly as Orix’s good reputation has been so crucial for securing the finance for the investment strategies the company has pursued.

Transparency was forced on Orix by necessity. It was founded in 1964 as a joint venture between three trading firms and five banks, “a small, simple equipment-leasing company in Osaka”, Takeda recalls. Only six years after it was founded the leasing business became independent from its shareholders — with hindsight a sound strategic choice, but one which at the time meant the fledgling business had to look elsewhere for funding. “Japanese capital markets were underdeveloped at that time so we looked at foreign markets to supplement our funding. Our name was unknown in the foreign market at this time, so we started company presentation meetings — which would now be known as IR roadshows,” Takeda says. “We were one of the first Japanese companies to start such presentation meetings focused on [foreign] investors and markets.”

It was this which set Orix apart from its peers and paved the way for its current status — almost without equal in Japan. (Its nearest competitor in the leasing business, Hitachi Capital, had revenues of 112.73 bn yen in 2005/06, just 12% of the Orix group’s total, although it has diversified far less.) Orix’s exposure to foreign — mainly institutional — shareholders, particularly in the US and Europe, forced the company to build a reporting structure that features a high degree of transparency demanded by its investors, heeding the dictates of a more stringent regulatory environment than was then prevalent in Japan. In another pioneering move, Tokyo-listed Orix floated on the New York Stock Exchange in 1998, only the second Japanese financial institution (after Tokyo Mitsubishi Bank, as giant Mitsubishi UFJ was then known) to do so.

“We are subject to Japanese regulations, various US SEC requirements, and at the same time the Sarbanes-Oxley Act,” Takeda says. “So we are different from most other Japanese companies. We have a more extensive regulatory environment. This gives us a unique corporate-governance structure.” A good reputation has allowed Orix to expand the range of its financing — a move pursued partly through necessity, as Japanese banks squeezed credit during the 1990s, the “lost decade” of economic stagnation. This has included the issuance of non-bank commercial paper, unsecured corporate bonds and, building on expertise gained in joint ventures in the US, asset-backed securities and commercial mortgage-backed securities.

Orix’s internal response to its foreign investors afforded a financial advantage. “Credit-ratings agencies are becoming more and more aware of the importance of corporate governance,” Takeda says, “because in order to have a thorough understanding of any company to which they assign ratings, financial information is not enough.” S&P’s Yoshizawa is positive about Orix’s reputation, despite its recent bad press. “We recognize that Orix’s corporate governance is excellent; probably it’s true that their listing on the NYSE has given them pressure from investors to maintain good standards,” he says. Orix’s ratings reflect this, as well as the group’s sound financial fundamentals. Standard & Poor’s raised Orix’s ratings from BBB to A- in August 2005. Moody’s hiked its assessment of Orix from Baa3 to Baa1 the same month.

Satisfying foreign shareholders has brought dividends, but also amplified tension between two primary objectives of any CFO: ensuring stability and driving growth. Takeda’s philosophy has been molded by this tension, a dilemma that confronts the management of any publicly listed company. Orix’s atypical ownership structure — and its sympathy with the Murakami Fund’s original objectives — puts Takeda under more pressure to deliver steadily rising profits than the average Japanese CFO. “Our foreign shareholders regard Orix as a growth company. I as CFO have to take such initiatives to maintain a good balance between profitability, financial stability, and growth,” he stresses.

Japanese CFOs are hardly known as buccaneers. Takeda, however, sees intelligent risk-taking as essential to the company’s long-term strategy. Even as most Japanese businesses sought to limit their liabilities in a downturn, Takeda was afraid that by being too cautious Orix would lose opportunities to fulfill its shareholders’ expectations. Orix’s debt-to-equity ratio is now around 5:1, although it had been more highly leveraged in recent years. “If we wish to improve this [ratio] further, we could. But achieving a lower ratio might jeopardize our growth strategy,” Takeda argues. His views on Orix’s credit ratings reveal the same philosophy. Even after the S&P/Moody’s upgrade, he says, “I am not personally satisfied with our level of ratings. But I think at the same time we should not necessarily achieve triple-A. Maintaining a triple-A rating is sometimes a trade-off between growth strategies and stability.”

Diversify, Diversify

Orix’s growth strategy has involved expansion strategically and geographically, with a boldness and scope that put it in a class by itself among major Japanese financial-services firms in recent years. During this period, much of corporate Japan busied itself by consolidating and downsizing operations to cope with the triple threats of asset deflation, the Asian financial crisis, and a credit crunch as Japanese banks struggled with huge volumes of non-performing loans. “Orix is a very unique Japanese company. We’re atypical in that we’ve been pursuing growth strategies, not reducing or downsizing our operations in an adverse economic environment,” Takeda says. Satisfying its shareholders’ demands gave the company little choice.

Consequently, Orix has a very diverse range of revenue streams, from operating and financing leases — its core, low-margin business, focused on auto and equipment leasing — to insurance, corporate rehabilitation, loan servicing, real-estate-related and other specialized finance and, most recently, investment banking and value-added services. (Its operations also extend to activities as diverse as golf-course management and running the aforementioned baseball team.) In the year ending March 2006, Orix had operating assets of 5.86 trn yen and revenues of 947.8 bn yen — encompassing operations in 23 countries that employ over 15,000 people. Its business diversification has accelerated in recent years. In 1997, the year Takeda was appointed CFO, direct- and operating-lease operations accounted for 55% of revenue. Last year, the same units accounted for 33% of revenue.

This diversity has been driven by necessity: in a period of asset deflation and, latterly, zero interest rates, trying to make money (let alone boost profitability) from low-margin debt-oriented businesses is a tough job. At the same time, Takeda cautions, “expanding our assets in a time of economic recovery is not necessarily good policy”, especially considering the impact of deflation, so the emphasis has been on expanding value-added financial services and making use of the distressed assets of less quick-thinking firms, whether in the form of real estate or problem loans. Corporate rehabilitation has been a particular focus, beginning with the purchase of Aozora Bank (nationalized in 1998 before being sold to a variety of investors, among them Orix, in 2000). Including Aozora, Orix now has 11 corporate rehabilitation projects on the go, in sectors as diverse as retailing, transport, restaurants, and life insurance.

Orix’s growth in the last decade and its current position show how successfully its ambitious strategies have been applied. Profits have been growing steadily, even in an adverse economic climate. Earnings per share over the last decade have achieved a compound annual growth rate of 16%. Net profit for the last financial year rose 82% to 166.4 bn yen, the third consecutive record and the first time profits had exceeded 100 bn yen. (Operating profit rose to a provisional 217 bn yen, up 65% year-on-year, and is estimated by Goldman Sachs to rise another 16% this year). And return on equity, the shareholders’ key concern, has rocketed from 6.5% in fiscal 1997 to nearly 20% last year. As Natsumu Tsujino, an analyst with JPMorgan in Tokyo, says: “Recent earnings suggest that diversification is really working for this company.”

Real estate in particular has become a core earner. In the last financial year, real-estate sales and real-estate-related finance accounted for 36% of Orix’s revenue in Japan; profit from the latter category rose 140% year-on-year to 33.3 bn yen. Deregulation has been one factor in this stunning growth, with a proliferation of new opportunities as Japan’s financial markets have belatedly begun to offer products long available elsewhere — some of which Orix has pioneered in Japan following the development of such businesses in its ventures abroad. For example, Orix entered the commercial mortgage-backed securities business through a joint venture with US-based Banc One in 1997 — now a 100% Orix-owned subsidiary called Orix Capital Markets. Leveraging such expertise in Japan has been a major positive. According to Tsujino, “Orix was best-placed to apply the skills they had learned [in the US] relatively quickly in Japan, and they have been able to do much better than other megabanks and regional banks” that were focused only on the consolidation of their domestic operations as a result.

Risk Versus Reputation

But diversification brings risk. Many of Orix’s newer businesses are less closely connected to its core expertise — that is, providing leasing solutions to around 500,000 small-and medium-sized enterprises (SMEs) in Japan. The risks associated with its newer businesses are therefore more substantial, as S&P’s Yoshizawa explains. “Those new businesses, all forms of principal financing, are high-risk, high-return businesses, so if they go into such fields, our thinking is that they have to prepare enough capitalization for entering them. For a leasing company their revenue sources are really diversified. We have to carefully monitor their new activities,” Yoshizawa says.

Orix’s key strength, according to Tsujino, has been in building on its core customer base. “Orix’s current advantage is its relationship with SMEs, where the margins tend to be high…From this kind of customer base it is relatively easy (for Orix) to secure the profitability of their operations,” Tsujino says. “They already have a network so they have a source of customers for real-estate-related investments. And their ordinary business is also going to help them get focused on their special services business; they already have information on customers’ needs in each area.” So as long as Orix doesn’t move too far, too fast from this base, its earnings outlook is unlikely to deteriorate. Overstretch seems unlikely given the group’s focus on this customer base. According to Yasunobu Doi, an analyst with Moody’s in Tokyo: “Orix would not pursue an aggressive and unduly incautious investment strategy at the cost of jeopardizing its existing SME customer base. It would only enter into strategic financial investments that it considers would enhance its relationship with its SME clientele.”

This is apparent even in the case of the group’s most recent business line, one which Takeda sees as “one of our most important strategies in the coming years” — investment banking. In October last year, Orix bought US investment bank Houlihan Lokey Howard & Zukin, as the next step in developing the company’s corporate finance business. Leveraging Houlihan Lokey’s expertise for Orix’s existing SME clients in Japan is the underlying aim. “They’re a middle-market player in the States, and have value-added expertise in investment banking,” Takeda says. “We’d like to bring their expertise to Japan to explore opportunities here. There will be more and more M&A in Japan coming to the market. So far, most M&A transactions have involved major companies, but we are expecting to see more M&A activity even in the SME market.”

Nevertheless, the speed with which Orix has entered new markets could be behind the problems it has had with ensuring internal management controls, as at Orix JREIT and Orix Asset Management. Since the beginning of 2005, Orix JREIT has spent more than 90 bn yen purchasing new properties. Orix Asset Management has evidently had trouble keeping up — and such were the potential returns on offer, no one was willing to slam on the brakes. Of itself, a slap on the wrist from the FSA is not a major problem, and is unlikely to affect the company’s earnings outlook, according to Nomura’s Iimura. (As a proportion of total revenue, earnings from the business are “not significant”, according to the head of investor relations at Orix, Raymond Spencer.) But, Iimura says, “the issue here is that I worry if the Orix JREIT problem could affect Orix’s entire real-estate-related finance business”.

It is not that Orix is moving away from its core clientele in real estate and real-estate-related finance. Orix has long experience providing financing to businesses and individuals ignored by large banks, which do not have the capability — or the will — to assess the credit risk profile of this customer base. Orix has exploited this in a number of ways. From May this year it began to offer small-ticket non-recourse loans. Secured solely by expected returns on the target property, these loans do not require guarantors or extra collateral. This means, if the target real-estate has the potential for profitability, the loan is available to anyone. The risk to the creditor lies in the soundness of the assessment of future profitability.

Normally, such loans (which started in Japan in 1999) have very high minimums, around 1 bn yen, given the high costs associated with setting up special-purpose companies — a measure normally necessary to protect borrowers if the target property turns out to be a dud. Orix intends to circumvent the need for SPCs, enabling it to offer loans starting from 100m yen per project. Although this is another high-risk, high-return principal financing business, the company is banking on its expertise in assessing SME and individual credit risk to succeed. Using this expertise, it is also building alliances with regional banks that want to use Orix as a guarantor for loans to SMEs, and developing its loan-servicing business to assist struggling regional banks and credit unions.

So far, so good, but as the company comes to rely more on real-estate-related activities to drive profits, increasing competition and thinner margins will reduce the profitability of Orix’s core business. Japan’s megabanks are likely to start targeting SME businesses as the economy picks up and credit gets easier to obtain. Some skeptics wonder whether Orix is doing enough to ensure profitability. Takehito Yamanaka, a Goldman Sachs analyst, writes: “Profits have surged over recent years as the company has recouped returns on investments made and businesses begun particularly between three and five years ago. With profit margins having risen sharply, however, next-stage development is needed to drive margins even higher.”

Yoshizawa agrees, questioning whether the stunning growth in the real-estate sector can be maintained. “It’s difficult to imagine that they will maintain this kind of momentum, because this field is highly competitive, and also because of the volatility of demand,” he says. And further expansion in this market, especially in light of the problems at Orix JREIT, raise concerns about whether the company has the means to ensure high standards of management control and corporate governance as it continues to diversify.

Still Not Satisfied

Takeda admits that some of Orix’s peripheral interests are still wobbly — as the problems at Orix JREIT suggest. “Whenever we consider diversification, we always check whether we have expertise and know-how,” Takeda says. However, “in a couple of these operations, Orix does not have first-class, strong management expertise…There are other major players with a larger market presence and perhaps are more profitable.”

Analysts like Yoshizawa are confident that “Orix’s risk control is relatively trustworthy”, but the problems at Orix JREIT raise questions about the internal oversight of its non-core operations. These are concerns Takeda acknowledges, despite their limited impact on the group’s earnings outlook. In spite of the effort that has been put in over the years, “we are still not satisfied with our corporate governance and we would like to improve,” Takeda says. IR chief Spencer, mindful of the impact of recent developments on Orix’s stock price, is keen to appear contrite. “We have been putting a lot of emphasis on compliance over the last couple of years,” he says, but after the SESC investigation, “obviously we are going to have to put more emphasis on it going forward.”

In Japan, evidently even the pioneers still have much to learn.

Going Back to China

Expansion across Asia has been a hallmark of Orix’s growth strategy for a long time. Its first Asian joint venture was established in Hong Kong in 1971. It now has operations in 14 countries in the Asia-Pacific region, focused mainly on its core leasing business. As of the end of 2004/05 its Asian operations comprised around 500 bn yen in operating assets and employed around 2,000 people. In the year ending March 2006, the Asia-Pacific/Europe segment contributed around 9% of total group revenue, and profits from the segment were up 44% year-on-year. However, there is one market in which it had been conspicuous in its absence until recently: China.

Orix’s wariness about China stems from the bad experience it had there in the 1980s and early 90s. In 1981 it began a joint venture with a local partner to establish China’s first leasing company. Orix’s CFO, Shunsuke Takeda, cites China’s inadequate legal framework and poor infrastructure at the time as the main reasons for Orix’s decision to wind up its first foray into the China market (as well as state-run enterprises’ curious attitude to debt, which meant the operation was quickly saddled with a mountain of non-performing assets). “After such a bad experience, we’ve been watching the market very carefully and the market is now radically changing,” Takeda says. Consequently, Orix has reentered China, starting with an 80% stake in a 550m yen equipment-leasing company in Tianjin in September 2004. It has also taken a 25% stake in a 2.2 bn yen state-owned railway leasing firm and, in September 2005, it set up a majority owned subsidiary — Orix China Corporation, capitalized at 1.1 bn yen.

Most recently, Orix decided to get a slice of China’s red-hot property sector, in February 2006 taking a 10% stake in Tian An China Investments, a property-development firm with 20 years experience in the market and revenues of 30 bn yen in the year ending December 2004. This exercise might seem a little late, judging by the Chinese government’s recent efforts to slow property investment to prevent overcapacity (which has already whittled down margins considerably). But Takeda is confident that the property market in China is “still developing”. It is a market which Orix can’t afford to ignore, Takeda calculates. “The Chinese economy is still expanding and getting more and more important for Asia and global economic growth. There are still some problems to be solved but I think it is undoubtedly true that China is more and more important,” Takeda says, nonetheless describing his attitude to the country’s prospects as one of “cautious optimism”.

Orix is cautious about being burned a second time. Natsumu Tsujino, an analyst with JPMorgan in Tokyo, sees Orix’s China strategy as a natural progression, given the company’s track record in Asia. “Orix already has finance-lease and operating-lease businesses in various parts of Asia, including Indonesia, Thailand, Pakistan, and Australia. So actually it is natural that Orix is going to go into China,” she explains. And the strategy is better thought-out than last time. “Rather than starting from scratch they have taken a stake in a major real-estate company, so I think this is okay,” Tsujino says.

Ryoji Yoshizawa, an analyst at Standard & Poor’s, agrees, although he is concerned that Orix is in uncharted waters — especially with regard to China’s real-estate market. “It’s fairly difficult to comment on profitability in the Chinese market, because it is developing and [Orix has] no track record. If they think it’s profitable, they will gradually increase their exposure to the market. At the same time,” he warns, “if they’re going into the Chinese market with large exposure, they will have to be very careful.” — DL

A Diverse Recipe
Orix’s revenue by segment*
(US $M)
% of Total
In Japan: 6,922 83.6
Corporate financial services 832 10.1
Automobile operations 1,113 13.4
Rental operations 571 6.9
Real-estate-related finance 592 7.2
Real estate 1,692 20.4
Life insurance 1,170 14.1
Other 952 11.5
Overseas: 1,355 16.4
Americas 598 7.2
Asia, Oceania, and Europe 757 9.1
Total 8,277 100
Source: Orix
*Year ending March 2006

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