Anyone who thinks markets are perfectly rational and efficient hasn't met Wilbur Ross.
Ross is a former bankruptcy attorney who saw there was big money to be made unlocking the value of assets irrationally shunned by the markets. He starts by shorting the stocks of weak companies in industries in the midst of a death spiral. Then, once a target goes into bankruptcy, Ross steps in and buys the assets for a fraction of their book value, selling them off a few years later for several times what he paid for them.
Ross's "empire of the damned," as BusinessWeek once called it, includes Japanese banks, Korean insurance companies and U.S. textile mills. But this week, he made his biggest score yet with the sale of International Steel Group. You may not have heard of ISG, but you surely have heard of the fabled steel companies that were folded into it -- LTV, Bethlehem, Wierton -- all of which Ross picked up in the past two years for about $2 billion.
According to TheDeal.com, the sale of ISG for cash and stock worth $4.5 billion will net Ross a 12-fold gain on the original $100 million investment from his private equity fund. Other early-stage equity investors, including Washington's own Howard Hughes Medical Institute, will enjoy a sevenfold gain on their initial $343 million stake. And those who bought shares for $28 at last year's IPO can satisfy themselves with a 50 percent return in less than a year.
This financial alchemy is not all that hard to understand. It's amazing how much you can improve the bottom line of a company when you simply wipe mountains of debt off the books and stop paying for pensions and retiree health care. In the case of ISG, about $2 billion of pension liabilities were foisted off on the government's insurance fund.
But Ross also took care to negotiate a breakthrough new contract with the United Steelworkers that reduced pay and benefits, shut down inefficient plants, outsourced non-core functions and reduced the number of job categories from 32 to five -- in the end, cutting the number of man-hours needed to produce a ton of steel by more than half. At the same time, he eliminated several layers of management and used the clout of combined sales and purchasing organizations to drive harder bargains with suppliers and customers.
Finally, Ross was clever enough to buy these distressed assets when steel was fetching less than $300 a ton, while selling when prices topped $550.
What's curious, however, is why so many parties allowed Ross and his investors to benefit from this restructuring rather than getting together and taking the necessary steps to capture the gains for themselves.
When bankruptcy threatened, why did the steelworkers union refuse to strike similar deals with previous managements? Why weren't executives more ruthless in closing uncompetitive facilities, outsourcing services and cutting out management fat? Why didn't creditors signal their willingness to restructure debt? And why didn't other investors move in and outbid Ross for the assets?
The answer, of course, is that we aren't as rational as economic theory assumes. Countries decide that it is a matter of national pride to make their own steel rather than import it at lower prices. Companies cling to the thin hope that the other firms will save them by going under first. Management gets so set in industry practices that it can't imagine another way of doing business, while unions grow so distrustful of management they'd rather let the company go down than give another inch. Directors, blinded by pride and spooked by sunken costs, are reluctant to close plants and cut their losses. And investors remain notoriously risk averse, even in the face of overwhelming evidence that they'd do better breaking from the herd and taking bigger risks with even bigger potential payoffs.
It is a testament to the self-correcting nature of the U.S. economy that there are a few well-funded Wilbur Rosses around who, by exposing and profiting from these inefficiencies, manage to salvage what's valuable from once-mighty industries. Some call them vultures. You might call them heroes.
Steven Pearlstein can be reached at email@example.com.