(Bloomberg) -- A record number of Japanese investors are putting their money into domestic private credit deals in search of higher returns in the world’s last major holdout for negative interest rates.  

An unprecedented 236 limited partners — including pension funds, insurers and regional banks — have provided money to private capital managers this year through September, more than triple the level of 2017, data compiled by Preqin show. 

The surge in the number of investors reflects potential returns of around 10%, compared with benchmark Japanese debt yielding less than 1%, and currency hedging costs that can wipe out income on overseas debt like US Treasuries. 

While the nation’s private credit market of about $8 billion makes up less than 1% of the global pool, it is also getting a boost from an increase in leveraged buyouts, especially those involving company management, which are at the highest on record. Corporate restructuring is gathering pace in Japan, with large companies spinning off non-essential operations while small-to-mid sized business owners confront succession planning.  

“There are credit and liquidity risks, but since these are Japanese deals, there isn’t foreign currency risk,” said Takatomo Hirano, manager of the investment planning department at Dai-ichi Life Insurance Co. “We can get relatively high returns from these yen-denominated investments compared with government bonds and corporate bonds.”

“Private credit in Japan is often used in situations that address fundamental problems facing the Japanese economy,” said Hiroshi Murao, managing director and chief financial officer at MCo Corp., a private credit manager. “When business owners think about succession planning, one answer is a management buyout. There are cases where the management team is handed over to the next generation, while in other cases, management professionals such as private equity funds are asked to participate.”

Despite all this potential, there are concerns that an expected end next year to decades of near-zero interest rates in Japan will make it harder for firms to repay debt. More than two-thirds of economists surveyed by Bloomberg see the BOJ scrapping its negative rate by April, with half of the 52 respondents saying it would happen that month.

“We are being very conservative in analyzing whether or not companies can repay their loans if interest rates rise,” MCo’s Murao said. “In the past there was less sensitivity as to when interest rates would rise and such analysis wasn’t necessarily important, but the environment has changed now.”

Analyzing Risks

Japan’s credit market has yet to mature, said Yu Kosaka, deputy general manager of the finance and investment planning department at Nippon Life Insurance Co., which has invested a limited amount in domestic mezzanine funds. When the market is immature and still developing, it’s difficult to analyze risks appropriately for the portion of funding given outside the amount covered by bank loans, he added.

“There isn’t much of a track record for the private credit market in the event of shocks,” Kosaka said.  

Japan’s private credit deals remain relatively small, typically in a range of about ¥30-¥70 billion ($200-$480 million), of which lending makes up around ¥3-¥10 billion, according to mezzanine lenders. 

There are only about a dozen private credit firms in Japan, including MCo, Keystone Partners Co., Topaz Capital Inc., MCP Mezzanine Co. and Fivestar Mezzanine Co. 

But for some investors, low yields and high hedging costs are making private credit assets too alluring to pass up, according to Masayoshi Terada, managing director at MCP Mezzanine. About 40% of the private credit fund manager’s limited partners are pension funds, while 20% are insurers and the rest are regional banks, he said.  

“Investors are looking for attractive opportunities in domestic private credit deals as high hedge costs would eat into returns that Japanese investors can make by investing in overseas debt,” Terada said. 

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