by Connie Bruck
Among those who had profited from these yields, First Executive and Columbia were by far the most aggressive for their respective industries, but other insurance companies and thrifts were entering the market. The original handful of high-yield mutual funds that had been created at the inception of junk had grown to twenty-six, with assets of $5.5 billion. Pension funds had come into the market; the World Bank’s was one of the first, with a $20 million investment in junk in 1980, and it was followed over the next several years by those of such blue-chip corporations as IBM, Xerox, Atlantic Richfield, Standard Oil, General Motors and others.
There were many tributaries, but virtually all flowed through Milken. Many of the pension-fund managers, for example, asked Milken to refer them to someone with expertise in junk bonds, and Milken steered some to the mutual-fund managers. Says one mutual-fund manager who claims to have turned down such an offer, “It happened to every mutual-fund guy at some point—Mike would say, ‘Want to run some private accounts?’ And if you said yes, then you’d owe him.”
One who did not turn down the favor was David Solomon, who ran First Investors’ high-yield mutual fund. Solomon ran some of the pension-fund money of the World Bank (he had been recommended along with several others by Milken) and other corporations, as private accounts under a separate group, First Investors Asset Management. This business became so lucrative that in early 1983 Solomon walked out of First Investors, taking the entire junk-bond staff and five of the company’s seven private-account clients (which had an aggregate portfolio of nearly $300 million). He set up his own company, Solomon Asset Management. Among the clients Solomon took were the World Bank pension fund and First Executive (which pulled out $80 million from its $120 million First Investors portfolio and invested $90 million with Solomon).
Every business and profession has its network, through which referrals and favors are exchanged. What set this one apart was its utter dominance by a single individual. Milken, and Milken alone, was in a position continuously to demand and to dispense favors. He had the product. He had the trading capital. He knew, with his phenomenal memory augmented by his computer system in Beverly Hills, where nearly every bond was. He dominated not only the primary market (of original issuance) but the secondary market (trading). As one junk aficionado put it in a frequently uttered refrain, “Michael is the market.”
No buyer of junk who might suddenly need to get out of a position could afford to be on Milken’s bad side—for having refused to buy some bonds Milken needed to unload, for example. “Mike’s favorite expression,” said one mutual-fund manager, “is, ‘I’ll make it up to you.’ ”
And the controls which Milken manned so zealously, in his twenty-hour days, operated a financial machine of increasingly awesome power. For the 1983 junk-bond conference, Milken performed what would become his annual ritual: he calculated, roughly, the total of his guests’ buying power. “Our access in this room,” he declared, as recalled by one guest, “is one hundred billion dollars.”
These yearly announcements always bore the embellishment of Milken the showman, since—even with his legendary persuasiveness—his guests’ portfolios were not wholly consecrated to junk. But, Milken’s hyperbole notwithstanding, it was clear by this time that he had tapped a demand so massive that it could outstrip the supply that was available from Drexel’s “traditional” financings. If his machine were to achieve its fullest potential—and if he and Drexel were to continue to dramatically beat their profits from the previous year—he would have to find a new source of product.
Increasingly, he and Joseph were both convinced that the well-spring had to lie in mergers and acquisitions, or M&A—where investment-banking firms were reaping multimillion-dollar fees for their firms on a single transaction. As the profitability of Wall Street’s traditional businesses had declined with the slashing of commission rates through deregulation, and long-standing ties between corporations and their investment bankers had been replaced with a free-for-all competition for underwritings, M&A had emerged as the Street’s hottest growth business. Before 1976, most investment-banking firms had not even had separate M&A groups, but by 1983 at the premier firms—Goldman, Sachs; Morgan Stanley; First Boston; Kidder, Peabody—these were major profit centers.
This latest merger wave was the fourth that this country had seen. The first occurred in the late 1890s, when monopolies like U.S. Steel and Standard Oil were formed. The next lasted from 1919 to 1929, the year of the crash, when companies like General Motors and Pullman expanded. The third occurred from 1960 to 1969, when the bull market fueled what were essentially paper deals, and conglomerateurs were able to acquire much larger companies with their companies’ overpriced stock.
The current wave began in 1974, when one pillar of the business establishment, International Nickel Company, raided another, ESB. International Nickel, moreover, was aided in its depredations by the ineffably white-shoe Morgan Stanley. With that, the class barrier was broken, and hostile takeovers became acceptable for elite companies and their investment bankers and lawyers. The International Nickel raid was followed by other hostile cash takeover attempts by blue-chip companies, all looking for quality, well-managed target companies.
While the volume of these deals was much diminished from the late sixties, the size of the transactions began to grow. In 1975 there were fourteen mergers with a value in excess of $100 million; in 1977 there were forty-one; in 1978, eighty. By 1979 the deals could be tallied according to those with a value of $1 billion or more: there were three that year, one in 1980, nine in 1981, five in 1982, and nine in 1983.
This wave had been triggered in part by the market crash of 1974, which created abundant bargains. Then inflation swelled the value of corporate assets, but the stock prices did not rise to reflect those values. So it became much cheaper to buy a company than to build one.
The country’s tax and accounting system, moreover, encourages the assumption of debt—as occurs in these leveraged takeovers—at the expense of equity. Corporate income is taxed to corporations, and dividends are taxed to shareholders, creating a double tax. It is easier for a corporation to pay interest (on debt), which is tax deductible, than to pay dividends (on stock), which are not. A company in the 50 percent tax bracket can afford to pay a rate of 16 percent interest as easily as a rate of 8 percent in dividends. And the individual investor, who has to pay taxes on either the interest or the dividend, will generally prefer the higher interest payment.
By the early eighties, additional factors had come into play. With the Reagan administration, antitrust restrictions became obsolete. Giant oil-company mergers that would never have been allowed in the Carter years became boilerplate. And companies of many parts that had been assembled in the conglomerate era began selling off odd pieces and acquiring other companies in their main line of business.
Banks—the crucial participants—had joined the M&A fray with a vengeance. Although in 1975, when Crane made a tender offer for 25 percent of the Anaconda Copper Company, no big New York bank would even act as an exchange or escrow agent for the bonds, such inhibitions had now been overcome. With deregulation, banks lost most of their low-cost deposits and were forced to offer money-market and other high-interest-bearing accounts. Furthermore, profit margins on short-term loans to corporations became thin because the banks had to compete with commercial paper. So the highly lucrative loans for takeovers became much-sought-after business.
With the 1981 Economic Recovery Tax Act, the tax system slanted the board still further toward the assumption of debt in these leveraged deals. This legislation was intended to spur economic growth by allowing companies to take extra-rapid depreciation. When they did that, cash flow grew faster than reported earnings. Stock prices, therefore, did not get the boost that they would have gotten from higher earnings, but the added cash flow increased companies’ ability to service debt—and enhanced their appeal as targets.
In addition to all these factors which gave rise to acquisition fev
er, there was Wall Street, fanning the flames. By 1983, investment bankers had abandoned their traditional roles as passive advisers and were now shopping deals frenziedly and becoming expert at handling multibillion-dollar transactions. But Drexel could not win the blue-chip clients that were the real players in this arena, and so it was relegated to the periphery, with small-time deals.
By the end of 1983, Drexel’s M&A group had produced $10 million in fees, up from $6 million the year before. The group was run by David Kay, one of Joseph’s “Shearson Mafia” hires from the seventies, a dapper type who seemed more Seventh Avenue than Wall Street (“We’ll take a gross of zippers, David,” one of his colleagues would kid him). Joseph recalled telling Kay that in the major firms’ corporate-finance departments M&A was accounting for 40 percent or even 50 percent of revenues. Drexel’s corporate-finance department that year had had revenues of $115 million (including M&A’s $10 million). So, Joseph argued, Kay was not even close to pulling in his competitive share. “I told him that it was time for us to make a quantum leap in M&A, and that I thought we had to do it by tying in our financing.
“We had some other ideas,” Joseph said, “like underwriting dispositions for companies—using our financial muscle to go to a company and say, You want to sell that division? We’ll guarantee you a price of forty million dollars. And then if we couldn’t get the forty million we’d make up the shortfall, but at least it would give us the merchandise.”
Drexel could not shop deals the way other firms did, because it had no merchandise. A firm like Goldman, Sachs, with its roster of Fortune 500 clients, often served as a marriage broker between those clients and made princely fees. But Drexel had no sizable M&A product, and no entree to the world that had it.
Six years after Drexel began underwriting original junk, it had created a $40 billion market, increased its profits geometrically, made fortunes for Milken and his chosen, provided what was essentially venture capital to scores of midsized companies, and brought bountiful returns to thrifts, insurance companies, pension funds, high-yield funds and others. But it was still an outcast in the major corporate world.
Drexel had found the “edge” for which Joseph had been casting about back in the seventies, and it was lined with gold. But money had never been the touchstone for Joseph. His aim, from the start, had been to create a world-class institution. And he was convinced now that Drexel—like the firms that laid claim to such status—needed to become a big player in the M&A field.
What would become Joseph’s “quantum leap” was actually only a small conceptual step forward from what the firm was already doing. Starting in 1982, Drexel had begun raising the “mezzanine” financing—by selling junk bonds—in leveraged buyouts. In a leveraged buyout, as it came to be known in the eighties, a small group of investors, usually including management, buys out the public shareholders by borrowing against the assets being purchased and then repays the debt with cash from the acquired company or, more often, by selling some of its assets. LBOs are structured like an inverted pyramid, with senior, secured debt at the top (typically about 60 percent, provided by banks); mezzanine, unsecured debt in the middle (about 30 percent, which Drexel provides with junk bonds); and a smidgen of equity, the prime filet of the deal, at the bottom.
A number of firms—among them Kohlberg Kravis Roberts and Company, Forstmann Little and Company, Clayton & Dubilier and others—had been specializing in LBOs for many years, some starting in the early sixties. The LBO is, after all, simply an investment technique, in which you hock the assets of the company in order to buy it—similar to the way many real-estate deals are done, with second and third mortgages. The LBO firms would buy companies in partnership with their management. By being made equity partners, those managers were given incentive to trim costs and augment efficiencies. And by the use of leverage, the value of the equity holders’ investment often grew phenomenally.
In the sixties and seventies, the LBO market consisted mainly of buying private companies or divisions of public companies. LBOs that involved taking sizable public companies private did not start until about 1980.
And it was not until William E. Simon, former U.S. Treasury Secretary, pulled off the Gibson Greetings deal that the LBO became the craze of Wall Street. Wesray, the private investment group that Simon headed, acquired Gibson Greetings from RCA in 1982. In 1983, when Gibson Greetings went public again, Simon’s group emerged with a remaining holding of about 50 percent in Gibson—and a profit of $70 million. By 1984, the dollar amount of completed LBOs would increase fourfold within the year, to reach $18.6 billion.
Though Drexel had not pioneered the LBO, it was a match made in heaven. It was a philosophical fit: the LBO represented a shift of control from a bureaucratic organization into entrepreneurial hands. And it was an extension of what Milken had been doing since 1977, when he started to help his clients to leverage their balance sheets with high levels of debt, through the issuance of junk bonds. Indeed, that realignment of the balance sheet—in which debt, with its tax-deductible interest payments, was so favored—had been explored by Milken in the paper he wrote in 1973 (after leaving Wharton) with one of his professors, James Walter. Entitled “Managing the Corporate Financial Structure,” the paper examined ways of optimizing investor returns by modifying a company’s capital structure, and compared that to the management of an investment portfolio.
“Notwithstanding the focus of most corporate executives upon the operating side of the business, opportunities for profit enhancement also exist in the financial end of the business,” Walter and Milken wrote. “The liability and net worth segments of the balance sheet represent portfolio positions that are subject to modification as conditions warrant. Neglect of such matters is patently inconsistent with rational behavior.”
In raising the financing for LBOs, Drexel would be doing what it did best—for the mezzanine level of unsecured debt in these highly leveraged deals was by definition junk. Before Drexel, that financing had generally been raised from private placements with a handful of insurance companies. But Milken had his legions of ready buyers, raised on a diet of just such high-yielding debt from companies with highly leveraged balance sheets. In 1982 Drexel placed the mezzanine financing for two deals, and in 1983 it did two more. Investment banker Leon Black, the only one in corporate finance besides Fred Joseph who seemed to have Milken’s respect, headed the LBO group.
From there, it was a natural progression. If Milken could place the most difficult portion of debt in an LBO, which is a friendly, negotiated takeover, why couldn’t he do the same thing in an “unfriendly LBO”—which is a hostile takeover using debt?
In November 1983, Joseph, Milken and members of their respective teams met with Cavas Gobhai in a suite at the Beverly Wilshire Hotel, next door to Drexel’s new Beverly Hills office, to engineer the quantum leap. As Joseph recalled that meeting, “We started by asking, ‘Where does our financing muscle really come into play?’ One thing that’s hard to finance is unfriendly acquisitions. You can’t finance them, because you can’t tell people you’re going to do the deal, and you don’t know if you’re going to need the money, and you don’t know how much money you’re going to need, because you may have to raise the price, and you don’t have access to the inside information, and a lot of people don’t like to get involved in unfriendly deals.”
Those were the problems. By the end of that two-day session, Milken, Joseph and the rest had decided to find a candidate so that they could start experimenting with solutions to them in the real world. Within a few weeks, T. Boone Pickens, targeting the Gulf Oil Company with his pygmy-sized Mesa, became their first test case.
But the germ of this new wildly egalitarian system—in which, before long, anyone (with Milken behind him) could take over any company, no matter how large—had begun to grow about a year earlier, at yet another Gobhai session.
“We wanted to position ourselves so that Drexel had an awesome M&A capability,” Joseph recalled, “because w
e had the access to the money and the power.” They wanted to become so strong that companies doing deals would clamor to hire them—even if only to neutralize them. At the time, it was the stuff of fantasy, the daydream of omnipotence of every have-not.
At that 1982 session, Joseph and the others drew up a list of the people who were the stars of the M&A world. It included Martin Siegel of Kidder, Peabody; Eric Gleacher of Lehman Brothers; Bruce Wasserstein of First Boston; Felix Rohatyn of Lazard Frères; Ira Harris of Salomon Brothers—and lawyers too, like Martin Lipton of Wachtell, Lipton, Rosen and Katz, and Joe Flom of Skadden, Arps, Meagher, Slate and Flom.
At a Gobhai session, of course, all ideas are entertained, no matter how outrageous. This list, therefore, was not a literal recruitment list; Flom, for example, was not seen as a potential candidate, although his ties to the firm would grow as Drexel became one of his firm’s five biggest clients over the next few years. But Joseph would later say that there were four on that list whom they did want—and Martin Siegel was at the top. “I took Marty on then, as my assignment to recruit,” Joseph would say four years later, in an interview in mid-1986 shortly after Siegel had left Kidder to join Drexel.
When that list was drawn up, the idea of persuading any of those individuals to join Drexel was, as David Kay put it, “chasing rainbows.” Before it could have even the faintest hope of luring one of those stars, Drexel had to bust its way into the M&A preserve, through sheer financial force. And one way to do that—which would be implemented not literally but in spirit—emerged at this session.
Drexel’s problem was that it had no Fortune 500 client with a billion-dollar bank line to wage a takeover. But what if Drexel had the billion dollars, at the ready? Or what if they said they did (and got it later)? And what if, by their staking the word of the firm on this claim, the world believed it and acted accordingly? In the new lexicon—and universe—that Drexel would soon create, this concept would become known as the “highly confident” letter. But for now it was christened (for its emptiness) the Air Fund.
