Ross to the Rescue

Back to Contents of Issue: June 2002

Alex Stewart spoke to Wilbur Ross to get the lowdown on saving Japan -- American style.

by Alex Stewart

Wilbur Ross is known as the 'king of bankruptcy.' Even over the phone as he sat in his New York office several thousand miles away, he sounded surprisingly precise and academic about the problems and opportunities facing private equity in Japan, not at all like the turnaround artist, or larger-than-life character one imagines. He is definitely one of the doyens of the turnaround game, and since the acquisition of Kofuku Bank (see the Kansai Sawayaka Bank story on page 22), one of the highest profile foreign investors in Japan.

After a 26-year career at Rothschild Inc. in New York, Ross departed in 2000 to take over management of a $450 million fund, which Rothschild had originally raised in 1997 to invest in Asia recovery situations. WL Ross & Co. now has $1.25 billion in assets, or "core funds," as Ross puts it, under management. WL Ross holds the master partnership and invites other investors to participate in particular investments as they arise. The purpose is that money can be directed into areas where partners generally have "strategic interests."

How do you apportion your investments geographically?
Over half our money is in the US, about one-third in Japan and one-sixth in Korea.

Why then did you chose Kofuku Bank as your first investment in Japan?
It was in fact our principal target at the time we took over the fund. Bear in mind the history. We established the predecessor of the fund when I was at Rothschild. We had raised $200 million in 1997. We were already very knowledgeable about the banking sector because we had done a lot of bank restructurings, especially regional banks in the US, but also a Mexican bank and Banco di Napoli in Italy. Banking, therefore, was a natural choice for us. In Japan, we decided to do a retail bank and not a Shinsei type (Shinsei was the former Long-Term Credit Bank now owned by the Ripplewood Holdings of the US). We were interested most of all in banks with extensive branch networks, frankly outside Tokyo, because we believed it would be less competitive. We also wanted to be in an area which had a high concentration of small businesses. We would very much like to be in Tokyo long term, but we wanted to start out in an easier place. Based on what we've done we now feel we are ready to compete in Tokyo, and we're very keen to enter. In terms of the choice of region outside Tokyo, Kansai was easy. It is one-fifth of the Japanese economy, and bigger than the whole of Italy. It has a high concentration of small- and medium-size companies. In Japan there are more than 4.5 million businesses with fewer than 500 employees and Kansai accounts for much more than 20 percent of them.

Regarding the choice of bank, we felt Kofuku had good branch coverage and its problems were fairly specific. They did not involve morality questions -- no self-dealing or other inappropriate transactions -- and we didn't find any either. This is very important, because if you have problems with yakuza it is very difficult to achieve a turnaround. Kofuku rang a lot of other bells for us too, so we went to government and the trustees and asked to be invited to bid.

What were the biggest problems?
We had assumed the economy was going to be difficult, but frankly it has turned out more difficult than we expected. We were not counting on a Korean V-shaped recovery but we had hoped the economy would be stabilizing. Certainly, therefore, the first year has been difficult, and particularly in Kansai, so this is our biggest single problem.

Conversely what has been the happiest surprise?
Without doubt the quality of both our new senior management, the existing middle management and of our clerical staff. We carried out an awful lot of due diligence on the staff before the purchase. We were concerned too whether the bank's borrowers would be happy with the new owners. I'm glad to say the reception from them was even more friendly than we had hoped, so this was the other big surprise.

Apparently you reduced the head count by half. How did you go about evaluating staff?
We hired PricewaterhouseCoopers; they developed an evaluation system for us. We then interviewed down to a certain level of management, and we set essay questions for the remainder. People often complain how long it takes to get a deal done in Japan, but it is not all bad if you are able to use the time wisely. In our case it took 15 months, but during this time we could use the lead time for dealing with HR issues. It also meant we could hit the ground fast when the deal was closed. The result is that investors have gotten a better return on investment in the first year. Similarly, with the loan portfolio we had more time to do an initial analysis. We could look at the portfolio three months after our initial analysis, six months after and so on -- each time we could see how our assumptions matched our initial analysis. In a US situation you do not have so much time and so you must try to find good quality people quickly. In Japan, on the other hand, we had time to interview over 100 people, six of whom we hired.

What is the quality of deals like in Japan, and how do they compare with South Korea?
Any country has plenty of good and plenty of bad. People complain particularly about the accounting differences. However, if you have a reasonably good understanding of how it works, the problem isn't so bad. I reject the notion that you cannot do US style due diligence in Japan. You have to understand the limitations of how the accounting works, and also look beyond the financial statements. This again takes time and effort. It also depends on how good your people are on the ground. With the help of Pricewaterhouse and Daiwa Securities, our office in Tokyo and our office in New York, we were perfectly able to do the due diligence. Still it takes time because you have to peel away a couple of layers of the onion. But you can get good lawyers, good accountants. They are expensive and it is time consuming, but I don't agree that it is so much more difficult than in the US.

Can you explain what you mean by "layers of the onion"?
This is more true of industrial companies than banks, but there is the problem of consolidated and unconsolidated subsidiaries. They are vastly different concepts from the US. In banking there are big differences between what is or is not a nonperforming loan. The Japanese view has tended to be more generous than the US judgment. There was a time when by regulation a loan was not nonperforming until it was six months in arrears. I think the people who are having difficulty in Japan are those who don't understand the macro differences and the due diligence process. You can see examples in the same industry, for example, Merrill Lynch, which bought Yamaichi, and Salomon (Salomon Smith Barney; part of Citigroup) which tied up with Nikko. Salomon has been very successful. Deryck Maugham (vice-chairman of Citigroup and chairman of Citigroup Japan) had oversight of the process. He knows Japan. He understood what was needed. Now Nikko is a strong No. 2 or 3. Before Salomon came in, it was much weaker. The difference is in execution.

How easy is access to deal flow?
It is not as orderly as it is in the US. In the US a company puts itself up for sale in a fairly public way. It isn't very difficult to get the 'book' (the company's confidential financial data) if you're willing to sign a confidentiality agreement. In Japan, it's more private. Some large companies will show their book, but generally it is more informal. The seller is more likely to approach people it knows. This is because companies are concerned with more than economic issues. For US companies price tends to be 99 percent, and other things, what I call aesthetic considerations, tend to be small. In Japan it is more about employees, suppliers and customers. We like this better because where non-economic factors are important you can get economic factors on more advantageous terms. In the US you could arrange a deal with very little marketing and just pay a big check. In Japan you won't see this. But you have to realize too that the whole M&A business is very new in Japan. Before 1997 there was very little, especially cross-border. It's not surprising in countries where there has been very little M&A that the infrastructure for doing deals is limited. More and more though, I expect it to become like the US. Deal flow is starting to get more orderly, but being accepted as a worthy buyer will remain a big hurdle for newer entrants to overcome.

Is the government in Japan as open to foreign investment as it was in 1999? And how does the government attitude to foreign investment compare with Korea?
I think the government is still as open as before. When a country experiences an economic recovery as Korea has, there is a natural tendency towards economic nationalism though, and then ownership by local companies becomes more important. This is what is happening in Korea. Certainly Japan and Korea are more open than pre-1997. President Kim Dae-Jung has been a very strong proponent of foreign investment and reform, but with his term of office coming to an end, he is becoming a lame duck president. As skirmishing over his successor increases, it is getting harder for government to be as decisive as it was before. Hopefully this will be resolved as the succession problem is resolved.

Overall, which is the more attractive destination for investment, Korea or Japan, and why?
There are more opportunities in Japan than in Korea. Firstly, the economy is much bigger. Secondly, in Korea when the crisis occurred there were only six chaebol groups who controlled about half the economy. Japan is not so centralized. Also it has many more small- and medium-size firms and the economic malaise has lasted longer in Japan giving a relatively higher percentage of companies stronger motivation to take in foreign capital.

Is China an option you consider for your funds to invest in?
We follow events in China closely, but at the moment the legal system is not quite as clearly defined as we would like. Since everything we do is related to distressed assets, it is important we have clear bankruptcy laws. The courts in Japan and Korea are relatively clean and free of political influence, and certainly of corruption. This is not true of many countries in Asia. When other Asian countries develop a stronger judiciary, which is less susceptible to politicians and corruption, then they will be attractive to investors like us.

Do you think foreign capital is becoming less attracted to Japan? Is there more the government can do to encourage it?
Last year there were 40 LBOs (leveraged buyouts). To see how much interest there is you should check out the Jetro New York Web site. Jetro just held a big private equity conference in New York. I was expecting about 50 people, mostly Japanese, but there were 261 attendees. It suggested to me that there is a lot of interest. It even alarmed me a little -- I'd prefer fewer people were interested! Looking at Japan we assume it is going to take 12 to 18 months to get an investment deal done and the lead time is similar in Korea. In the US the process is generally 30 to 60 days. It is probably therefore very frustrating for the average fund coming into this market. But once a fund has become established and has a backlog of deals going through things should start taking off. Our objective is only to do two or three decent deals, not hundreds. Other players may have more glamorous expectations and that's why they could be unhappy. We heard Unison Capital at the conference and they sounded as if they were doing very well. Also Tim Collins (chairman of Ripplewood Holdings) sounds happy with Japan. Lone Star seemed happy with things (Lone Star bought Tokyo Sowa Bank and renamed it Tokyo Star Bank). The last thing in the world we want to do is to withdraw from Japan. If anything we are inclined to do more there.

What is the climate like for investing in the US now? And how much of your time do you give to your investments in the US?
I'm not looking for a sharp V-shaped recovery in the US. It's going to be more of a wobbly W. Eventually there is going to be a good recovery. What isn't noticed sometimes is that there were a record number of bankruptcies last year: 172 companies with liabilities of over $100 million failed last year; the aggregate size of the debt was $229 billion. This is an all-time record in the US. It was two and a half times higher than in 2000 and that was up on 1999. So, even while the country may be coming out of recession there is a vast outpouring of bankruptcies. Note here that 14 percent of all high yield bonds are in default. That's out of a total of $730 billion. There is another 24 percent which is distressed, yielding 15 percent or more. The only reason a company yields 15 percent is because investors don't expect it will pay many more coupons, so we expect this big flood of bankruptcies will continue. However, this will be against an improving US economy so it is a good environment for our funds. Our staff is 80 percent based in the US, but I spend one week in six in Japan. This is largely because we are doing bigger deals in Japan than the US. In the US you can do a profitable deal with as little as a $2 million investment, but that's not going to work in Japan.

How about your overall confidence in Japan? And do you think prime minister Junichiro Koizumi is the man to lead the country?
We have confidence in Japan. It is still the second largest economy. One-third of the savings worldwide are held by Japanese citizens. You can't ignore that! It has had a positive net balance of trade every month for over 20 years. We're also encouraged by the devaluation of the yen. In fact I've been saying for a time that a weaker yen is a good way to solve Japan's problems. Consumers are not going to stop saving, and corporations don't want to invest because they have over-capacity, so exports are left as the key driver to get the economy going. Every 10 cent decline in the yen exchange rate relative to the dollar adds probably half a percent to GDP growth. If the yen weakens too far, to say JPY150, then this would put too much pressure on the currencies of other Asian countries, which could cause devaluation. But it is still possible for the yen to weaken another 10 percent. When a currency is overvalued, as the yen has been, the inevitable result is a devaluation of locally denominated internal assets. On the other hand, if the currency depreciates, it will cause the value of internal assets to rise in yen terms.

I'm less bearish on Koizumi than many people. His decision not to put off removing the deposit insurance on time deposits was a correct one. It is already causing depositors to make a value judgment about which banks to use. This is very healthy. Reform of government ministries is also good. There are more reform-minded people active now. We are finding, and so are others, that government decision-making, while still sometimes opaque, is getting clearer. There is more attention to fairness of process. These steps are all important, and they are going in the right direction.

Any other advice you would give government to make Japan still more attractive to investors?
The most important thing is that government sends positive signals to investors, like the Jetro conference did. The very strong support from the Japanese government on the US response to terrorism also helped symbolically to strengthen US-Japan relations. All of this is very welcome to US investors. If I were in charge I would certainly aim to get the yen down another 10 cents. That would solve Japan's biggest problems. @

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