In research for my forthcoming book on global industrialization, I have been examining recently the career of the Japanese business titan Eiichi Shibusawa (1840-1931). Shibusawa, still something of a national hero in Japan, was effective head of the Dai-Ichi Bank from its founding in 1873 until 1917. More important, having while working for the Ministry of Finance introduced the concept of broadly held public companies to Japan, he was then involved as a private equity investor in the founding of nearly 500 of them. A superb networker, he both invested his own money and brought together resources and management for each new company, focusing always as his Confucian ethic demanded on the long-term interests of both the company and Japan. His approach, while difficult to pull off, would greatly improve the private equity business today.

To enjoy any such career, you need to be not only an individual of remarkable ability and stature but generally regarded as such by the outside world. Warren Buffett is the obvious modern U.S. example, but Buffett’s deals with Berkshire Hathaway have almost all consisted of acquisitions of existing companies whose shares had become undervalued – he has founded very little de novo. Shibusawa generally did not engage in such deals; the acquisition market in 19th century Japan was underdeveloped, with no equivalents of Goldman Sachs harrying managements to engage in spurious deals, so Shibusawa only occasionally guided companies in which he was invested to merge with another company, buy another company or sell out to a competitor. Instead, most of Shibusawa’s investments were start-ups of one sort or another, a strategy of much higher risk, requiring much more analytical intelligence in the strategist.

Shibusawa grew up under the quasi-feudal pre-1868 Shogunate in a village 50 miles north of Tokyo (then known as Edo) where his father was a modestly wealthy small farmer with a side business in indigo balls with annual turnover of around $3 million in today’s money. As a farmer, his father ranked well below the martial samurai in Japan’s caste system, but above the merchants, with their un-Confucian greed for money. Rural entrepreneurship had been encouraged by the reforms of Shogun Yoshimune (ruled 1716-45) of which this column wrote some months ago.

From his upbringing, Shibusawa derived a decent education in the Chinese classics and through the family business an understanding of commerce, finding around 100 customers for indigo balls among local dyers and textile weavers and going on buying trips for their main ingredient of indigo leaves. He also inherited a dislike of the shogunate’s feudalism; as his father said to him “There are two things you can’t argue with: a crying child and your feudal lord.” After an early experiment in rebellion, which nearly proved fatal, Shibusawa attached himself to a feudal lord “daimyo” who then himself became shogun, but in a stroke of luck sent Shibusawa on an 18-month trip to Europe to attend the 1867 Paris Exhibition, in a party led by the shogun’s brother. Shibusawa picked up the rudiments of capitalism, in the rackety laissez-faire society of Napoleon III. (Japanese who went to Europe a few years later, after Napoleon’s defeat by Germany came to admire the authoritarian Second Reich, not a good development model, as it turned out.)

In 1868 the shogunate was overthrown by the daimyos of Satsuma and Chosen, who nominally backed the young Emperor Meiji (1852-1912, ruled 1868-1912) and set out reforming the government and introducing Western industry. Their objective was not to make the Japanese people richer through industrialization but to make Japan militarily competitive. On his return to Japan after the Meiji Restoration, Shibusawa first started a local trading company on behalf of the ex-Shogun, which made a good return, then was summoned to Tokyo to join the Ministry of Finance. Here he wrote a handbook on public companies, about which he had learned in France, then a company law. In 1872, he was central to drafting a banking law, for a system modeled on the U.S. National Banks, in which he specified a broad base of shareholders for each bank, to prevent them becoming oligopolies. As a shareholder in the First “Dai-Ichi” Bank, buying 400 of the bank’s 24,400 shares he was made first its Superintendent and then its President. He would remain at Dai-Ichi Bank for 44 years, using it as his base of operations; his position as its President gave him instant credibility in raising capital for new ventures.

Shibusawa’s company formation activities focused mainly on adapting Western technologies to Japanese needs, on a scale that would be internationally economic. For example, his 1882 textile company Osaka Cotton Spinning (later Toyobo) was five times the size of previous government-established textile companies with Western technology. Sometimes he founded a company to take advantage of Westernizing tastes, for example Sapporo brewery. When necessary, he identified management and sent it to the West to be trained in the latest techniques; in 1885 he founded the Dragon Gate Society, a networking operation for promising new management. Returns on the investment of Shibusawa and others came in the form of dividends paid out by successful companies rather than capital gains. Those dividends were then used to fund further investments (income tax in Japan was at single-digit levels, so dividends flowed through properly to investors). Shibusawa occasionally funded new investments by borrowing from Dai-Ichi Bank, secured by his existing holdings, but this approach was limited and became more so as his wealth increased.

Overall, Shibusawa founded a dozen companies that are still in business and part of Japan’s blue-chip Nikkei-225 Index, a tribute both to his skill and to the greater stability of Japan’s corporate sector. As with Dai-Ichi, he normally carried out public share offerings at the outset so that each company was fully independent, and “democratically” controlled. Share buyers included major corporations but also wealthy individuals, the nobles and samurai remaining from the Shogunate. Those wealthy but unsophisticated investors learned to trust Shibusawa promotions, having previously burnt their fingers in the banking sector, where 153 new banks, consecutively numbered, were founded before 1879, attracting ex-samurai founders and capital because the ex-samurai were convinced that banking did not require inappropriately commercial skills – at least the two swords of the samurai were useful in debt collection!

Part of Shibusawa’s sales pitch to investors was that he was founding companies on Confucian principles, so that those companies would benefit society as a whole and not simply make money. The sales pitch worked because it was largely true, but the staying power of Shibusawa’s creations indicates their economic soundness and ability to reward investors in the long-term. Shibusawa’s long-term, societal-benefit, “Confucian” approach to private equity investment, being rewarded by dividends and avoiding “financial engineering” games could usefully be adopted today.

Such a Confucian approach to private equity would need to follow Shibusawa’s principles, including that management must have “skin in the game” in terms of cash investment. The current practice would have to cease: of rewarding any halfway plausible entrepreneur with 30% or more of a company for which he did not put up any cash. The venture capitalist and the outside investors would buy cash equity along with the entrepreneur (who could be partly financed with a non-forgivable bank loan) with all investments being made at par, no fees being paid and all money raised being invested in the company directly. As an additional wrinkle, the entrepreneur could be given additional incentive in the form of deferred stock options conditional on corporate performance – thus leverage need not be eliminated altogether. The company once formed would covenant to pay at least 50% of its earnings in dividends and not engage in share buybacks or other leverage games.

It may be objected that such a structure would be much less favorable for the company’s founder than the current one, but if it included prohibitions against ousting the founder arbitrarily, it would give him protection that the current norm lacks. The current pattern of massive funding at a huge premium over net asset value is in any case a result of the current glut of private equity sources. As a reminder, the original venture capital investment by American Research and Development into Digital Equipment Co. in 1957 was of only $70,000 (about $1 million in today’s money) and gave the venture capitalist 70% of the equity. A Shibusawa structure, in which there was no dominant shareholder and equity was broadly spread, would not only be more “democratic” but would give more protection to the company founder.

Much of the spirit of Eiichi Shibusawa’s Confucian Capitalism is preserved in Japan’s corporate sector, which is far less prone to “churn” and financial games than in the West, and doubtless correspondingly more elevated in its ethical practices. It is a model to which we would do well to return; when the current private equity bubble has collapsed, we may well get the chance.

-0-

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)