by Connie Bruck
The REITs, however, were only a warm-up. It was in the early spring of 1977 that Milken and Joseph decided to collaborate on an undertaking that would provide an “edge” commensurate with Joseph’s ambition and would launch the firm on its trajectory. Lehman Brothers Kuhn Loeb, then one of the most prestigious investment-banking firms on Wall Street, had just underwritten several novel issues of low-grade, high-yielding bonds—$75 million for LTV Corporation, $75 million for Zapata Corporation, $60 million for Fuqua Industries and $53 million for Pan American World Airways. Until now, high-yielding bonds were the Chinese paper from the conglomerate-building exchange issues of the late sixties and from various and sundry fallen angels, high-grades which had been downgraded, including the REIT bonds. But these Lehman-underwritten issues were bonds which started out in life as junk.
Milken, who bought some of these bonds, pointed out to Joseph that he had the buyers for such low-rated paper—the clients he had done business with since 1970. For by 1977, prior to the public issuance of non-investment-grade debt—as Milken would later note with some pride—there was already a thriving, vital high-yield market. “The value of this thesis was tested in 1970, and even more in 1974,” said Milken, adding that the bonds of many companies, including Loews, Rider, Tandy, Westinghouse, and Woolworth’s, had plummeted in price in 1974; but within the next two or three years those prices rose dramatically.
“By 1977, what was important was we’d just gone through a difficult economic period, and people who had invested had had a very, very successful experience,” Milken continued. “Those investors who had confidence in ’74 achieved rates of return in excess of forty percent. And it was their enthusiasm that then fueled this market in 1977.”
The high-yield bond was indeed, as a Drexel publication put out by Milken’s department would say some years later, “a financial instrument whose time has come.” Historically, low-rated companies had borrowed money short term on a senior, secured basis from banks, and longer term from insurance companies in private placements (although some companies were too low-rated to qualify for the private placements). But those loans had been laden with restrictive covenants. The other source of capital, of course, was equity offerings—but those diluted the value of the stock already outstanding. Furthermore, the equity markets had been so depressed through the seventies that for many companies—particularly the contingent Drexel was attempting to serve—an equity offering was not even an option.
Milken was offering these low-rated companies a new financial instrument that blended the best of equity and debt: long-term, dilutionless, less restrictive capital. The average life of these bonds was fifteen years, with no principal payments due for ten years.
This was subordinated debt too, which meant it was subordinated to the claims of any senior-debt holders. If they wished, the companies could continue to acquire senior debt at a lower interest rate from banks—which would draw comfort from the level of subordinated-debt capital beneath them. Like a mountaintop-real-estate developer who builds one row of homes with spectacular views, sells them and then builds another in front, repeating the process until the latest row has reached the very cliff, the companies could continue to acquire senior debt, without interference from the subordinated-debt holders, who would be relegated to increasingly junior positions.
For Milken’s investors, there was not only the appeal of the high interest rate, to compensate for the additional risk, but some upside: these companies’ ratings might be upgraded. Furthermore, Milken guaranteed the investors liquidity. He told them that he would be there to make a bid on the bonds—it might not be a bid for what they had paid for the bonds, but it would be a bid. In essence, Milken was replacing more covenants (which an insurance company would have exacted in a private placement) with liquidity; so if an investor didn’t like what a company was doing—as his mountaintop view was obscured—he could always sell his bonds.
And for Drexel, these bonds offered a walloping commission of 3–4 percent of the principal amount, as contrasted with the standard rate of seven eighths of one percent charged for underwriting high-grade bonds. The firm was embarked on what Joseph would later describe as its “high-value-added” course: as the years went on, Drexel would charge ever more astonishing fees for doing what no one else could do.
Milken had his stable of clients, but if this market was to thrive it would need a much broader base. Milken and Joseph quickly determined, however, that they would not distribute the bonds through Drexel’s retail system. Milken followed the old Hickman credo on diversification. The retail customers with their small holdings would not have diversified portfolios, and without diversification Milken was convinced he would ultimately kill his clients.
The way to reach those retail buyers, Milken and Joseph decided, was to invent high-yield-bond funds, where the portfolio would be diversified. First Investors Fund for Income (FIFI) had been operating essentially as a high-yield-bond fund since Milken began tutoring David Solomon, in the midseventies. In 1976 FIFI had asked Drexel to raise capital for it. The project had foundered for close to a year, and now, in the spring of 1977—with the new junk bonds starting to be issued—Drexel’s G. Christian Andersen and David Solomon set out on a cross-country road show to raise about $17 million.
“We took the story of high-yield bonds to the masses and to Wall Street and started to acquaint people with what the performance record [of FIFI] had been,” Andersen noted. “I saw there was a real market out there.”
FIFI became the first of the new “high-yield” funds, followed by Drexel-led underwritings for about a half-dozen more before the end of 1977. This was when the nomenclature, at least at Drexel, changed. As one Drexel investment banker remarked, “We knew we couldn’t go to the public and ask them to invest in ‘junk.’ ”
For the public, the allure was simple: riskless Treasury bonds were then offering a return of about 7.5 percent, while the funds’ target was in the area of 10 percent. And for the fund managers whom Milken was assiduously courting, this new area sounded exciting. Mark Shenkman, who would later become a Milken devotee and was then equity-portfolio manager at Fidelity, had his first meeting with Milken at breakfast in 1977: “Mike said, ‘Why just be an equity manager when you could have a specialized niche, which takes into account equity research and trading inefficiencies, and offers good performance?’ ” Shenkman relayed the Milken pitch to Jack O’Brien, in charge of product development for the Fidelity funds, and soon Fidelity started its first high-yield-bond fund.
While the Lehman issues had been sizable, Drexel started out small. In April 1977 its first deal was $30 million of subordinated debentures at 11.5 percent for a highly leveraged oil-and-gas-exploration and equipment-manufacturing company, Texas International. Though in later years Milken would forsake the notion of a syndicate and loathe the existence of even a single co-manager—why give bonds to other firms to place when he had more demand than he could fill, and why risk their finding out anything about his distribution?—in the beginning he did spread the risk. In the Texas International deal, Drexel Burnham took $7.15 million of the bonds to distribute, and the rest were allotted in tranches of under $1 million to fifty-nine other firms. The underwriting fee on the deal was 3 percent, or $900,000, of which Drexel collected the lion’s share. In those days, that was a dramatically large fee.
By the end of 1977, Drexel did six more deals, all in modest amounts—ranging from $7.5 million to $27.5 million—and its total for the year was $124.5 million. While Drexel had done more deals than Lehman, Lehman ranked first for the year in amount, its total twice as large as Drexel’s. Moreover, White, Weld and Company, E. F. Hutton and Company, and Blyth Eastman Dillon and Company all gave Drexel a run for its money, weighing in with fewer deals but in dollar amounts that came close to Drexel’s.
That was the last time in junk-bond history that Milken’s competition would be able to touch him. In 1978 Drexel did fourteen issues for a total of $439.5 million, and its close
st competitors for number of issues and amount did six issues and $157.9 million respectively. From then on, the numbers would tell a story of Drexel’s dominance that grew more mammoth with each passing year, as the firm seized close to 70 percent of market share.
Lehman Brothers might have competed at the outset, but the business was too dicey for that high-class firm. Lewis Glucksman, the volatile trader who would for a brief, cataclysmic period several years later head Lehman, liked the junk business and believed the firm should make a strong commitment to it. But his partners on the investment-banking side disdained it. Lehman did only one more deal after that first batch and then turned down seventeen. They all went to Drexel.
Mark Shenkman, who left Fidelity in 1979 to set up a junk-trading operation at Lehman Brothers Kuhn Loeb, later recalled that “the big concern at Lehman was, ‘What will General Foods say [about its investment banking firm peddling such déclassé merchandise]?’ All the establishment firms were slow coming into this business because they wanted to protect their franchise with the blue-chip companies. Drexel had no franchise to protect.”
And Drexel’s lack of ambivalence showed in its commitment of capital to this new business. In 1976 Drexel Burnham had merged with William D. Witter, a research boutique in which the Belgian Compagnie Bruxelles Lambert, just months earlier, had purchased a controlling interest for about $20 million in cash. Drexel thus became Drexel Burnham Lambert, with a capital base of $67 million, and Bruxelles Lambert—controlled by Baron Léon Lambert—owned a 28.3 percent stake in the newly merged firm. Now, with the junk-bond business under way in the late seventies, Burnham says he went back to his Belgian investors for two separate infusions, of $10 million each, mainly for the Milken-Joseph venture. The Bruxelles Lambert stake in the firm went to 35 percent.
By 1978, Joseph had assembled his core corporate finance group, the half-dozen investment bankers who over the next eight years—to their astonishment—would each amass many millions of dollars. Among them was Stephen Weinroth, who arrived at the firm that year after stints as an investment banker at L. F. Rothschild and Loeb Rhodes and then as the chief operating officer of a private company.
Weinroth was drawn to Drexel because he saw a “happy constellation” in place. The medium-sized companies Drexel was targeting were indeed an underserved market, the high-yield bond was its perfect product, and Milken was already dominant in trading those bonds. Moreover, Weinroth—avuncular, rotund, hardly an investment banker in the white-shoe mold—felt temperamentally suited to these clients and the role he would play. “With medium-sized companies, you can really get to know the managements, and you can really help them. I figured I could make a difference. I wasn’t dealing with an Exxon.”
After Weinroth had been at Drexel for about six months, he would tell Fred Joseph that when he was at Loeb Rhodes two things had always scared him: when he was pitching a piece of business he was afraid he would lose it to Goldman, Sachs, and then if he got it he was afraid the firm would not be able to perform. At Drexel, these fears vanished. “I said, ‘Freddy, it’s too easy. This isn’t even fair, it’s so easy.’ ”
3
Transformation
WITH THE FIRM flexing its muscles so pleasurably in this burgeoning market, Milken in early 1978 announced to his immediate boss, Kantor, that he wanted to move his entire high-yield group to Los Angeles. He and his wife were both L.A. natives. The winters in the East were too hard on her and their young children, who were sick a great deal, and he and his wife were intent on going home. It was important to him to make the move soon, as his father was ill with cancer and he wanted to be near him. Furthermore, it made business sense: he would be able to work a longer day, since California was three hours behind New York.
There apparently were other factors. As one Drexel executive would put it, “The nervous Nellies at the firm, especially Tubby Burnham, were driving him crazy, always worrying about the size of his positions, and he wanted to put some distance between himself and them.”
Others said Milken wanted to escape the bureaucracy that was a requisite part of life in the firm, even for him, who had managed to shun much of it. Out in L.A. he would be far freer, while Joseph, more important to him than ever, would be his proxy back in New York. In sum, Milken would have his own fully integrated, insular, autonomous and delightfully faraway shop—the natural extension of what he had begun five years earlier, after the Burnham merger.
Milken’s decision hit the firm like a thunderbolt. It would cost the firm millions to open up a full-scale trading operation in Los Angeles. The very engine of the firm would be situated three thousand miles away. Milken, who was fiercely independent and aggressive, would be harder than ever to keep in check.
But the point is that it was Milken’s decision, not his request. Kantor said later, “What could we do? Mike was making one hundred percent of the firm’s profits.”
It was not as though Burnham and Company had been a shell when Milken arrived. The firm had been profitable every year of its forty-odd-year history. It had had the strength to take over Drexel Firestone at a time when many submajors were folding or being absorbed. But Milken’s profits were so astronomical that when the profits and losses of all the departments in the firm were calculated, the others canceled one another out and Milken’s profit figure was that of the firm, overall.
Almost as stunning as the fact that a thirty-one-year-old trader could dictate to a Wall Street firm that it move its major base of operations to the hinterlands of Los Angeles (where no other firm had even a meaningful outpost) was the fact that Milken convinced his entire East Coast staff of about twenty traders and sales and research people to move with him. The only people he lost were clerical.
The incentive, of course, was not mysterious. Through the investment partnerships that Milken ran, by 1978 his top people had already become millionaires. They were the envy of Drexel. An invitation to join them was a ticket to wealth. Gary Winnick, who had sold furniture before coming to Drexel in 1972 and by 1978 was selling high-grade bonds to institutions, recalled how Milken recruited him for the move West.
For the past two years, Winnick had worked across the trading floor from Milken. They had a passing acquaintance. Winnick said that he came in early and left late, as of course did Milken, and Milken noticed this. Later, Milken would tell him that he admired his work habits. In the spring of 1978, shortly after Winnick heard that Milken was moving his group to L.A., Milken—who had spoken to Winnick infrequently—asked him as they walked out on a Friday afternoon what he was doing that weekend. Winnick replied that he and his wife were going to look for a house to buy in Westchester County. “Don’t buy anything,” Milken said.
He’s got something in mind for me, Winnick thought to himself. He felt as though his heart were going to jump out of his chest. Winnick was then making about $50,000 a year. Milken’s people were widely rumored to be making half a million, a million, more—and they were no more gifted than anybody else in the business. He raced home to tell his wife what the wizard had said, to puzzle over those three words, to dream about what he knew could be—if the words meant what he hoped—one of life’s greatest opportunities. Several weeks later, Milken finally asked him to join.
Winnick was not alone in his assessment of Milken’s people as being notable only for their newfound wealth. “None of Mike’s guys was anything when he took them on—he created them,” declared one former Drexel executive. “What he wanted was bodies—but loyal bodies. Disciples.”
His faithful cavalcade moved west. In later years, Milken—who, though he would avoid the press, was not loath to cultivate the legend that grew up about him—would tell friends that he and his wife made the trip west by car, so as to afford him time away from the phone. She drove, and he sat in the backseat, mired in prospectuses.
Another story he told about this trip is more revealing. Not long before Milken and his wife began their journey, he (in Drexel’s account) had shorted some bonds with wa
rrants (to buy stock at a given exercise price) attached. When you short a security, you sell it to another party at a given price, for future delivery. What you are betting is that by the time of delivery, when you have to buy the security, its price will have dropped, so you will buy it for less than your selling price. As the Milkens started out, however, the company’s stock took off on one of the greatest runs of all time—and escalating with it, of course, were Milken’s shorted bonds and warrants.
“Mike said, the warrants were going up and up, there was nothing he could do—he just kept stopping and making calls from phone booths all the way to California. It was a very long trip,” recounts one former Drexel employee. “It would have been a very hard hit if it had been the firm’s capital that took the loss. But by the time Mike got to California, he had managed to lay off the position on his clients. He told that story laughing—especially the part about how he’d been able to lay it off.”
MILKEN AND HIS ENTOURAGE opened shop in a skyscraper at 1901 Avenue of the Stars, in Century City, on July 3, 1978—the day before Milken’s thirty-second birthday. For months there was no name on the door behind which they were trading. Some of Milken’s associates say he did this in order to show Burnham that the business was his and he didn’t need the Drexel name. Others insist that he felt a sign was unnecessary—his was not a walk-in business for the public—and that the anonymity suited him. “All Mike has ever wanted,” maintained one longtime associate, “is to be left alone to do business.”
Milken was serious about the longer workday. He set the clocks to New York time, so that everyone would remember that they were living by New York market hours. He expected his people to arrive by 7:30 A.M. New York time—4:30 A.M. California time.