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Wilbur Looks at the World: An Interview with Wilbur L. Ross, Jr., Chairman and CEO, WL Ross & Co., LLC With Keith W. Rabin, President, KWR International, Inc.
In 1999, Korean President Kim Dae Jung awarded Mr. Ross a medal for his help during nation's 1998 financial crisis. He is a former Chairman of the Smithsonian National Board. Earlier, President Clinton appointed him to the Board of the U.S.-Russia Investment Fund, and he served as privatization advisor to New York City Mayor Rudolph Giuliani. Mr. Ross serves on the Executive Committee of the New York City Partnership and of the Japan Society and is a member of the Chairman’s Circle of the U.S.-India Business Council. He is a member of the Business Roundtable and a Board member of the Yale University School of Management, which has presented him with its Legend of Leadership Award. He is also a member of the Committee on Capital Markets Regulation. Mr. Ross holds an A.B. from Yale University and an M.B.A., with Distinction, from Harvard University. Thank you Wilbur for taking time to speak with our readers. Before we start, can you take a moment and tell us a little about your background and how you got to where you are today. Our group had been managing the restructuring business at Rothschild and subsequently in 1997 began doing private equity investing as well. Then on April 1 2000 we bought the private equity business from Rothschild and went out of the advisory business to create the firm we have today. We have always worked on a global basis but for us the international part has largely consisted of Asia, including China, Japan, nowadays India and in the early days Korea. Most recently we also began operating in Vietnam. Today, we manage $4+ billion in assets in several funds for major pension funds and other large institutions. You spent much of your career focusing on the US and with the onset of the dot.com’s and Asian financial crisis in the late 1990s shifted to a more international focus. You then seemed to shift back toward the US with your steel, textile and coal transactions but now have been making acquisitions in China and India. How do you see the world, what are the markets of greatest opportunity and where should investors and policymakers be focusing their attention? In terms of China we have mostly been involved with direct investments in start up factories -- largely migrating production from higher cost parts of the world. We intend to keep on doing that. The inflation that has occurred there and the minor revaluation of the yuan relative to the dollar so far does not pose serious problems. In general, they are more than offset by the increases in sales from the domestic consumption that is now starting to kick in. Historically China’s economy has been extremely export and capital investment driven, and only now is becoming more consumption oriented. As a result, personal consumption as a percentage of GDP has been much less than in the West. In the US for example, it is around 70% -- a multiple of what is seen in China. So we think the next phase in their development will be a continuation of export, something of a diminution in the rate of increase in capital investment and a big increase in consumption as per capita income rises. We are not doing much in the way of distressed there, due to the relative absence of a legal system and the fact that most of the borrowers are government or quasi-government entities. Therefore it seems to us the workout process is more political than economic -- so we don’t think we can add much value. In contrast we have set up a dedicated workout fund in India in a joint venture with the Housing Development Finance Corporation (HDFC), a well respected institution there. It is the largest housing lender in the country, holding mortgages on about three million homes. It is a good partnership as they have a strong history of joint ventures with western institutions. There is no real conflict since we are not doing real estate loans and they are not particularly oriented toward corporate lending. This is our biggest new initiative and we have people on the ground in Mumbai. So far we were the first foreign fund authorized by the Asset Reconstruction Corp. of India, Ltd. (ARCIL) to take over a textile company named OCM, a well known brand in the worsted area in India. We are also extremely excited about Vietnam. In terms of its political and economic evolution, it is about where China was 20 years ago. Wages are about one half of China’s -- yet the workforces are equally disciplined, and they have a good work ethic and manual dexterity. It is not on the same scale since Vietnam has only about 85 million people, 1/20th as many as China -- but that is one and one-half times the population of South Korea. And when you think about how important South Korea has become to the world economy, I don’t see any structural reason why Vietnam over time cannot approach or exceed Korean levels. This is particularly true now that Vietnam has been admitted to the WTO and has achieved permanent normal trade relation status with the US. In both cases Vietnam had to make some real sacrifices in terms of its contractual obligations -- but it achieved these goals so we are very keen about opportunities there. Our principal activity has been to establish a textile joint venture with the government in the Danang area. The major exports from Vietnam to date have been shrimp, textiles and apparel -- so this fits very well into their industrial plan. The private equity market has been growing enormously in recent years and many would say there is too much debt and leverage, too much money chasing too few deals, and that bond yields are getting to the point where they will cap the broad market indices -- considering where we are in the economic cycle. How do you see this playing out, do you think valuations are becoming stretched and what adjustments do private equity practitioners need to make in light of these developments? Valuations have been going up partly due to the tremendous amount of capital available -- but probably even more so because of the relatively low interest rate environment and very permissive nature of debt markets. To provide a few anecdotal items, in the US, the average multiple of debt to EBITA in leveraged buyouts was about 5.7x in 2006. That is up from 4x in 2002 and just about back to the all time high reached before the credit bubble burst in the early 2000s. That is a danger sign. Also, interest coverage in leveraged transactions is now down to about 2 to 1. That also corresponds very closely to the worst in terms of ratings of high yield bonds. There have been tremendous quantities of these instruments in the last few years -- but about 1/3 of them have been rated single B or below. That is quite far into the junk category. And the uses of the proceeds are disquieting as well. Only about 13% has been used for capital expenditures to promote growth. Almost half has been for refinancing of existing debt or stock buybacks or dividends paid to sponsors. None of this is productive and most of the rest has gone for LBO transactions. So we believe both on a ratings and use of proceeds basis, the signs are there that perhaps by the end of 2007 or early 2008, there will be a big escalation of defaults from the currently low level. Back in the late 1990s you mentioned to me you were much more interested in Japan and Korea than China, ASEAN and India believing these markets to be more investor-friendly and better structured from a corporate governance perspective. What has happened in the interim? Have these countries addressed the deficiencies you perceived or have you just become more comfortable operating in these environments? A couple of things have happened. The Japanese recession from the 1990s into the early 2000s has now been pretty well rectified. So there are fewer distressed assets there. In Korea it is the same. Their problems were resolved more quickly and its recovery was V-shaped in the aftermath of the Asian financial crisis. Korea also, particularly in the last year or two, seems to have become less friendly to foreign direct private equity investment. You are very aware of the whole Lone Star (acquirer of Korea Exchange Bank) episode. Without trying to say who was right or wrong, that kind of gigantic public confrontation probably never would have occurred a few years before, so people have become a bit more concerned about the receptivity of the Korean public and government to foreign private equity than at an earlier period of time. Meanwhile a number of domestically-funded medium-sized private equity funds have emerged in Korea and are taking up part of the slack. So that is why we are doing less in Korea. As for why we are doing more in China, the country has continued albeit slowly to introduce a legal system and strengthen property rights. It has also tightened accounting standards quite a bit, and liberalized the percentage ownership a foreigner can have in many industries. Most significantly they have made gigantic strides toward fixing the balance sheets of banks and Westernizing the management structure of these institutions. Interestingly, what they have done is not sell whole banks to foreigners but rather permit major western institutions to take a strategic position, generally 5-10% of the equity and then infuse meaningful numbers of executives into the bank itself. The rest of the capital is obtained through an IPO. That is very different than Japan and Korea where the model had been to sell the entirety of the failed bank. The Chinese model has raised tens and tens of billions of dollars and taken care of some of the write-offs that were needed. Most importantly this has resulted in a better management structure. Since you then don’t have one foreign private equity entity making billions of dollars it also makes it easier from a political point of view in these countries. Last year, Stephen Roach of Morgan Stanley, who had been extremely bearish for years, highlighted the IMF decision to begin multilateral discussions to resolve major trade imbalances and remarked he was "now feeling better about the prognosis for the world economy for the first time in ages." Since that time we have seen concerted Central Bank tightening and many now predict an "end" of inflation, slowing growth and an end of a cycle that has helped to support financial assets beyond what might have been expected. What are your views on the inflation, deflation, stagflation debate and how do you view its implications, particularly from the perspective of the value investor. Each country is very different and one thing I learned a long time ago is that no one ever introduces himself as an Asian. They are Japanese, Chinese, Thai or whatever. Japan during much of the last decade had a severe deflation of asset values -- both securities and real estate. Now they seem pretty much beyond that. In China it was pretty much the reverse, with asset values soaring. How can an economy keep growing 10% a year? To my knowledge no economy of China’s size has ever achieved that – yet they have done it more or less without inflation. A little inflation is really not a bad thing anyway and that seems to be all they are experiencing. What you did have was an enormous boom in property values. You usually see that when a currency is fundamentally undervalued. Now the Yuan has appreciated against the dollar by about 5%. This is not a huge thing but it is the first sign in quite awhile of a loosening of the currency band. My guess is it will continue to inch along and gain relative to the dollar. I would be very surprised to see China unhinge from the US dollar completely -- as they know if they did that their currency would go up quite sharply. They are mindful of the dislocation that was created in Japan when their currency unhinged and went up too high to the dollar. The Chinese have proven themselves very adept at achieving economic growth with minimal internal stress. They never devalued during the Asian financial crisis and they are doing a very good job managing their economy. Thailand is a place where we are not operating so I am not as familiar -- but what is worrisome is the recent very temporary imposition of pretty draconian rules on foreign investment. This is scary as it was the Thai bhat problem that helped to precipitate the whole 1997-98 Asian crisis, so I hope Thailand will get itself back to a more even keel and minimize the danger of a big dislocation emanating from there. Many believe Alan Greenspan made a big mistake not tightening US monetary policy when he made his famous “irrational exuberance” comments in 1996, and since then excessive liquidity has lead to a series of bubbles and rising level of debt that now impinges on the Feds ability to tighten without placing the US into a severe recession. What do you make of the present state of the US economy and corporate America? How concerned are you about consumer debt and the housing market? Do deficits matter? Trade deficits do matter. While US dollars have been recycled in relatively benign fashion, there is no guarantee that will continue indefinitely. There is always the danger -- particularly now that there are more Euros than US dollars in circulation -- that foreign central banks will diversify their asset holdings more broadly. If so, that could have some profound effects on our markets and the US economy. Therefore it is very dangerous we have to increasingly rely on China, the Arab countries and Japan to be the source of capital for the combination of the trade and federal budget deficit. I think it would not be such a severe worry if we had just one of these two problems, but the US has both big structural federal budget deficit and what appears to be a structural trade deficit as well. That’s a tough combination. It limits government fiscal and monetary policy. So I think that is something to worry about. As for consumer debt, subprime lenders clearly are in for a very rough time and default rates are soaring. With the advent of collateralized mortgage obligations (CMOs), institutions that used to keep loans on their balance sheet are now in the business of originating, packaging, offloading and collecting service fees. That is a fundamental change in the relationship between lender and borrower and incentivizes lenders to make poor credit judgments. So if you have aggressive lending or over-advancement, combined with hyper-escalation of real estate prices and hyper-expansion of new real estate development, you have the precise ingredients that lead to bursting a real estate bubble. The only question is for how long and how severely will it burst. I think it is clearly burst, but it is not clear whether it will be a temporary correction denominated in months or denominated in years. Hopefully it will be months rather than years but at the moment there are not enough data to make a judgment. Furthermore, the two major consumer durables that households purchase are houses and cars. Since consumers have in the aggregate been net dissavers for two years in a row -- the first time that has happened since the great depression -- and whatever wealth effect had come from rising property values is over, the outlook for both housing and autos appears to be relatively constrained. Additionally, we now have 3 cars for every 4 people of driving age, so it is hard to visualize much more penetration of that market. For this reason I think we are in for a year or so of a relatively soggy economy. If both homes and cars are weak it is hard to imagine a tremendous amount of lift from an economy that is still running a trade deficit. So I think it will not be a very glamorous period for the next year or so but don’t think at this point there is any chance of going into depression or anything of that magnitude. Gold and precious metals have traditionally been seen as a safe haven and means of portfolio diversification, yet in recent years we have seen far more positive than negative correlation between gold and broad market indices. In addition, mining companies, which had been seen as leveraged plays on the underlying metals, often trade in less predictable fashion. Have these relationships changed? If so, why and what can we expect moving forward? Since we view globalization as the main economic driver, we believe the standard of living in developing countries -- which is after all where most of the people in the world live -- will rise over time. And when you are talking of levels around a thousand dollars per year per capita income -- that rise is largely denominated in increased consumption of commodities. So we believe in general there is now being superimposed on the normal cyclical outlook for commodities a strong secular growth trend that is liable to continue for some years. Last year we released a report entitled "Institutional Embrace of the Resource Market" which talked about growing interest in the sector. Given the relatively small size of the industry and lack of new supply, why hace valuations have remained as depressed as they have -- particular in the junior market? How long will it be before commodities become a mainstream investment? Are companies such as BHP or Rio Tinto the new Montgomery Ward or RJR in the sense they represent attractive targets? Why have major financial players outside the industry been reluctant to get involved in what has been one of the better investment opportunities in recent years? If we get through the next recession and earnings in those sectors don’t collapse, I think you will see a re-rating of the P/E multiples accorded to metals and mining firms. I think that is already starting to happen in the steel industry. As you know we are active with Mittal and believe one of the corollaries of globalization will increasingly be consolidation of basic industries. When those sectors consolidate, you have less pricing volatility since when you have multiple units of production in a few hands, there is a better ability to fine-tune production with demand. So I believe that steel stocks for example have been so strong partly due to strong earnings -- but perhaps more importantly investors are beginning to recognize that the earnings won’t be as volatile as they had been before. Therefore they deserve a better P/E than they had been accorded when they were seen as purely cyclical plays on the economic cycle. In terms of Oil and Gas, there is a different factor that is going in the opposite direction as so much of their production is in politically unstable areas. So I think that things such as what went on in Russia with Yukos or now with Gazprom or what Chavez has been doing in Venezuela with the major international producers has created uncertainty that frightens investors. What also causes fear is the cost of finding new reserves has gone up quite sharply and there has been a relative lack of major new discoveries in recent years. So the fear is whether the large energy companies are moving into the wrong part of the decline curve. In 2005 we conducted a survey concerning the international expansion plans of US technology firms. We concluded most mid-sized US firms were far from prepared to compete internationally, particularly in the Emerging Markets. Even more problematic was a seeming inability to shift from a paradigm that viewed these markets as sourcing platforms to one that views them as the drivers of incremental demand. Do you think US companies, beyond perhaps a few large multinationals, possess the capabilities needed to expand internationally? If not, how will the US benefit from increased demand in these economies? It is happening but very gradually. These days a lot of even medium sized US companies are having good experiences operating in countries like India. It was harder in earlier periods when the countries they were considering had language and greater social and regulatory barriers and a relative lack of a legal system. India obviously has a commonality of language and inherited a legal system from the British. Most importantly it has a huge base of engineers. The US graduates something like 60K engineers annually. China graduates about 200K and India 240K so there is a tremendous resource base out there. China’s growth used to be fueled by an arbitrage between blue collar costs in the west vs. much lower blue collar costs there. Today, however, in India and China, it is increasingly driven by the arbitrage between engineering costs. A graduate engineer in India gets about $10-12,000 and a Ph.D. a few thousand more. That is a tiny fraction of what they get in the west. So now a lot of the engineering and R&D know how is being moved to these emerging countries. That has very negative implications long term for the western world. If you combine high quality and large quantity of low cost engineering capability with high quality, low cost manufacturing capability there is not a lot of room for the developed countries. In an age where globalization and economic integration is the prevalent theme a more multi-polar world seems inevitable. Might this result in a shift away from the largely Anglo-Saxon business, legal and regulatory practices that have come to be seen as the "gold standard" by global asset managers and corporations? Most portfolios are becoming more and more accustomed to the notion they need considerable geographic diversification. It is relatively rare these days to find a big portfolio that is strictly invested in the US or Western Europe. With improved regulation of many foreign markets and telecommunications, Internet, Bloomberg, etc. it has become much more common to have investments in multiple jurisdictions. Even companies that are notionally American, have an earnings base that is becoming more global. It is getting harder and harder to find a Fortune 500 company that does not have a very meaningful slug of its earnings coming from offshore. In recent years you also have had the development of both Hong Kong and London as enormously important financial centers. That is partly due to excessive regulation in the US arising from the scandals that provoked Sarbanes Oxley and other reforms. Additionally, deals go to where deals are done, and those markets have become increasingly capable of providing capital and the investment banking sophistication that large issuers need. So I think you are going to see in both the manufacturing and financial sector much more geographic diversity than you have ever seen before. It has often been said that 9/11 changed everything. How concerned are you about the “War on Terror”, the present situation in Iraq, Iran and North Korea and the way in which the US and other nations are moving to address this situation. I think everyone has to be concerned about our government’s policy, which does not seem to favor negotiation as much as it does actual or threatened military action. We have not handled the Iraqi situation very well, but it is even trickier to figure out where do we go from here. Clearly the Middle East has the potential to be disruptive to the whole world -- because so many countries are dependent on it for their hydrocarbon supply. So hopefully someone, whether it be the new congress or the next administration, will figure out some way to reduce the temperature -- but it is definitely at a very dangerous level now in the Middle East. Can you talk a little about Japan and its economic prospects, changing Bank of Japan (BOJ) policy, the future of the carry trade, postal savings privatization, why the Yen remains inexplicably weak, how the environment there differs from the US and perhaps Western Europe and the challenges faced by its new Prime Minister and the nation at large. Part of the Yen’s weakness is due to speculators borrowing Yen to buy higher interest rate securities in other countries. But the weak Yen is very helpful to Japan’s balance of payments surplus. I believe that Mr. Abe will generally pursue the policies of Mr. Koizumi, but may not be strong enough to implement controversial initiatives like postal privatization quickly. Global integration is perhaps most pronounced in the financial markets and we are seeing far more cross- and ADR/GDR listings and the growth of derivatives and other instruments. How do you see this trend developing, what are the implications of a more global flow of capital and which financial centers do you see as the most competitive over the long term. As huge amounts of capital are created in China, India, Russia, etc., their domestic securities markets will continue to grow, especially if they strengthen their regulatory regimen. The US has accelerated this trend by overreacting to the handful of scandals in the early 2000’s. Hopefully the new Congress will preserve the good features and eliminate those that are unnecessarily costly and inconvenient. I am a member of the Capital Markets Committee that recently proposed many detailed revisions that have been generally well-received by the SEC, the Treasury Department and by the new Congressional leadership. Over time, markets will be more electronic and less physical and there will be consolidation of national exchanges into global trading platforms. To date, the US is the leader in this effort. Thank you so much Wilbur for sharing your thoughts with us.
Seth Lopez
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