The Predators’ Ball

by Connie Bruck

  By mid-’84, they had moved to Milken’s junk (bonds and preferred stock). Now they were making a spread of at least 400–500 basis points (there are 100 basis points in one percentage point), sometimes as much as 1,000. They would promise a return of 8 percent or so and then invest the money in junk that was paying 13–18 percent. Guy Dove came to be their trader—and Milken’s man in the shop. It was rumored at Drexel that Milken had an equity stake in Clarendon through his investment partnerships. But those partnerships were essentially run as blind pools, so even those at Drexel who had money in them generally did not know what their investments were.

  It was great while it lasted. Wedvick, who had reportedly been making no more than $70,000 a year at Shearson in his pre-Atlantic Capital days, now was said to be making about $10 million a month. His lifestyle lent credence to the talk. “I saw Peer not long ago,” one friend remarked, “and he was driving a Rolls Royce. But it was only one of them [that he owns].” When Wedvick married in early 1985, Drexel threw a bachelor party for him in Las Vegas and flew in friends and key clients. It was an extravaganza worthy of someone who was said at the time to be Milken’s biggest client.

  In these bond deals, it was typically the underwriter who decided which bidder would be awarded the investment contract. Major commercial banks and insurance companies flooded this market in the early eighties. But in California, where Atlantic Capital was most active, no institution could compete with it. There was no disclosure required as to how the funds would be invested, and most underwriters who accepted Atlantic Capital bids apparently looked to the AA rating and not beyond. Of a half dozen interviewed by this reporter, all said they did not know the money was being invested in junk bonds.

  One asserted, “For about two years, they [Atlantic Capital] were tearing up and down the state, getting any deal they wanted—it was almost impossible not to do business with them. And for a long time they managed to keep it very quiet, the rates they were getting. I remember I was with Peer in a restaurant in early 1985, and I said, ‘Peer, how are you doing this?’ And he said, ‘We’ve got the best options guy in the country.’

  “I can’t say what they were doing was illegal,” this underwriter concluded. “But it certainly failed the good-faith test.”

  If the underwriters were ignorant of how the money was being invested, FGIC (Financial Guarantee Insurance Company), the bond insurer which insured some of Atlantic’s investment contracts, was not. One analyst at FGIC says, however, that it was their knowledge of Atlantic’s investment strategy that caused them to limit the coverage to $300 million. What was worrying, this analyst adds, was not only that Atlantic was putting the money into junk, but that it was also committing a cardinal investment sin. Like the S&Ls which had borrowed short-term money and lent long, and so got caught when interest rates skyrocketed and had to pay more for their money than they were receiving on their long-term loans, Atlantic Capital had borrowed short (most of these funds had to be repaid in three years) and lent long (the securities they bought typically had maturities of ten years or more).

  “It was a game of musical chairs,” this analyst said. “They were using the new money that came in to make payouts on the old contracts. They weren’t liquidating the securities. So there was certainly the risk that if interest rates had risen, in the end there would not have been enough money in the securities [whose price would have fallen] to make the payouts. Or if there had been any big defaults [in the junk issues]. But there weren’t.”

  By the fall of 1985, it was essentially over. Standard and Poor’s finally exerted sufficient pressure on Kansa that that company refused to extend its “cut-through” agreements to any new investment contracts. Atlantic Capital stopped selling these contracts (it had sold about one hundred) by the late fall of ’85. Within the next year, Pesonen, who had led Kansa into the foray with Rocha and Clarendon, left Kansa to join Clarendon full time in its London office. He was replaced by a new chairman and management from outside the company who vowed to refocus Kansa on its domestic, rather than international, activities. And in December 1986 Standard and Poor’s downgraded Kansa from AA to A – (a substantial downgrade) in large part because of its relationship with Atlantic Capital and its concern about Atlantic Capital’s investment portfolio. Standard and Poor’s noted, however, that Kansa had already taken steps to allay its concerns. “In particular, Kansa General’s intention to no longer reinsure new exposures of its one-third-owned Clarendon Group will reduce over time the overall role in the company’s portfolio as those exposures run off.” Many of the bonds which had been backed by these contracts would also be downgraded by early 1987, so the bondholders were left with devalued bonds.

  Dove too by 1986 had shifted his base of operations to Clarendon’s London office. In December 1986, U.S. District Judge Owen Panner granted a preliminary injunction to the Princeville Development Corporation, allowing it to block the attempts to acquire control of it by Dove (through Garrison Capital Corporation, affiliated with Clarendon), Charles Knapp (through Trafalgar Holdings) and others.

  Among his other findings, Panner cited numerous disclosure violations by Garrison, including its having failed to disclose that it was acting as part of a group, in an attempt to seize control of Princeville. Panner also found that, while Dove and Knapp were posing as only sources of financing for the tender offer for Princeville, in fact that financing—through the issuing of warrants—would place between 40 and 90 percent of the equity in Dove’s and Knapp’s hands. The offer to purchase was fraudulent, Panner found, inasmuch as Princeville shareholders “were prevented from discovering that managerial control of Princeville . . . could pass to persons with, at best, dubious pasts: Dove and Knapp.”

  For Dove, Atlantic Capital was surely a once-in-a-lifetime kind of opportunity. Like other members of the Milken network, Atlantic Capital benefited enormously from the halcyon financial times in which it operated. Because Atlantic Capital’s gamble on interest rates was so great, the superb economic climate probably meant the difference between striking it rich and suffering a disaster. For others—companies which had issued mountains of debt, for example—the climate may have meant the difference between scraping by and prospering. But for everyone in this magnificently orchestrated, highly interdependent production—and for Milken, its maestro, most of all—timing was key.

  13

  The Enforcer

  IN THE VERY BEGINNING, from 1973 to 1977, when Milken’s universe extended no farther than to the next trading area, he had controlled the members of his small, clannish group with the investment partnerships. As the junk market began to take shape, he controlled some of the buyers, some of the issuers. The larger that market grew, the more important it became to him to control the whole, the more he conceived it in fact his responsibility to do so—because there was more opportunity for error, more that needed constant fine-tuning, so much more to protect; one tremor could be costly. And as Milken’s power grew, commensurate with his creation, the opportunities for abuse in the name of control, of expansionism, of disciplining the intransigent, of uprooting the indolent entrenched, also increased. It was for the greater good. He remarked to someone once that there was no corporate democracy in this country and there never would be unless it was forced. Milken was, self-appointed, the enforcer.

  It is axiomatic that the more powerful one is, the easier control becomes. As Milken became exponentially more powerful than the vast majority of his clients, many would not challenge him. And so he could gouge them, freely. As one Drexel employee said, “Mike is always saying, ‘If we can’t make money from (that means overcharge) our friends, who can we make money from?’ ”

  Norman Alexander, the chairman of Sun Chemical Corporation, met Milken in the midseventies when Milken sold him some of Riklis’ Rapid-American bonds. “I remember meeting Mike in Schrafft’s, and him showing me all the companies [whose bonds he was trading] on one sheet,” recalled Alexander. “He had made a market in these bonds. He had or
ganized himself among the players so that he could take you out when you wanted to be taken out—either because he had the capital or because he had the place to put it.”

  Alexander added that through the last fifteen years, that liquidity has remained constant. “So far, he’s always been there, and he’s been able to provide whatever oil was needed.”

  Once the original-issue market started, Sun Chemical became one of Milken’s early issuers, doing a $50 million offering of junk bonds in 1978. Alexander remained a satisfied customer of Milken’s through the years, investing personally in some of the superlever-aged acquisitions when they came along. On these deals, he said that he, like many others, tends not to read “the fine print.” Alexander explained, “The investment is made largely on your confidence in Mike’s ability to appraise the value of a deal.”

  Alexander is a longtime admirer of Milken, but he did register one muted complaint. In 1986 Drexel was selling a small company for him. It was charging him a commission fee that he estimated was double what other investment bankers would have charged him. But he did the deal with Drexel anyway. “Because if I didn’t,” Alexander recalled, “the next time I would say, ‘Mike, you have to get me out of Revlon,’ or ‘You have to get me out of Boesky,’ he would say, ‘Oh, and for twenty-five thousand you went somewhere else?’ So, you see, you tend not to go somewhere else.”

  One of his clients going somewhere else—not just on a deal, but even on a trade—Milken took as a personal affront. And he was so vigilant that he missed little that occurred in his market. One client recounted getting a call from Milken in 1986, when Milken was steeped in multibillion-dollar transactions. “ ‘You people just bought five million dollars’ worth of bonds through Oppenheimer,’ Mike said. ‘I could have gotten you those bonds for half a point better.’ I said, ‘How do you know, and more important, why do you care?’ And he said, ‘We want every piece of business.’ ”

  One rival trader said Milken’s omnivorousness goes even further. “Mike wants not one hundred percent but one hundred and one percent—because not only does he want to do all your business, but he also is not happy unless you actively trade, churn the account.”

  When Milken had 60–70 percent of the market, no one who intended to stay in it could afford to alienate him. Knowing they were being gouged by Milken but thriving on his merchandise, many of his clients had what one Drexel employee described as a “love-hate relationship” with Milken. Even some of those clients closest to him—Fred Carr, for example—actively (though privately) encouraged competitor investment-banking firms to enter the junk market. But while those firms did enter, they were not committed to that market the way Milken was. And how could they be? He had created it, he viewed himself as not only its progenitor but its guardian. They had come along, late in the day, for the ride.

  Morgan Stanley, which by 1985 was emphatic about its determination to be a serious participant in this market, underwrote $540 million of junk bonds for People Express from December 1983 to April 1986. But in the summer of 1986, when People was on the verge of bankruptcy and some of its bonds plunged to as low as 35 percent of their issue price, Morgan Stanley made itself scarce. No bids were forthcoming. James Caywood, who first started buying bonds from Milken as a money manager in the late seventies, said, “Where was Morgan? Nowhere! Who’s the only one who can tell you what’s going on? Mike. So you go crawling on your knees. I was only in it for five million, but still. He took me out of it. I thanked him. He said, ‘You don’t have to thank me, Jim—it’s my obligation.’ ”

  As Milken was approaching the zenith of his power, in 1985, there were some clients who so suited his larger purpose that he was willing to grant them more autonomy than most, or even take a beating from them in a negotiation. Carl Icahn was one, and Samuel Heyman was another. Heyman is a Harvard-educated lawyer and successful real-estate developer, who had taken over GAF in 1983. By the spring of 1985 he had substantially improved GAF’s earnings. Heyman was smart, studious, polished (a different breed from Peltz and Perelman), and he was gearing up for a major acquisition. That spring, he was talking to a premier investment bank about its underwriting $150 million of junk for GAF.

  Heyman had been a close friend of Eli Black, the former United Brands chairman, and had known Leon Black, Eli’s son, as he was growing up, so Leon Black became Drexel’s emissary, along with Fred Joseph. Heyman ultimately agreed to give the deal to Drexel, but he drove a hard bargain. Underwriters generally will not commit to exact terms until the night before the offering, when the deal is priced—and then issuers are at their mercy because they already have too much invested in the deal’s consummation to walk away.

  So Heyman insisted that Drexel agree to a fixed formula, with no leeway for negotiating at the end. He argued that the rating agencies were wrong in their assessment of GAF as a below-investment-grade credit, because they were so biased in favor of “companies with little debt, whose managers buy Treasuries and have no ideas.” This, of course, was an argument close to Milken’s heart. He told Heyman that in his next life he was going to set up his own rating agency. And he agreed that the issue should be priced as though GAF were an investment-grade credit.

  The formula Heyman bargained for was 115 basis points over Treasuries. The other firm which had been talking to Heyman about the issue was not willing to commit to a fixed formula. Milken, however, accepted Heyman’s terms. “Then Treasuries went down two hundred basis points, and the spread between the Treasury rate and the junk-bond rate widened dramatically,” Heyman recalled. This meant that Milken was committed to sell these bonds at a rate that was well below the lowest end (strongest credits) of the junk market. The GAF bonds were issued at eleven and three-eighths. “In the end, most firms would have said, ‘We just can’t do it,’ ” said Heyman. “But Drexel gave some customers a big discount, they did swaps, they put their commission money into it. Mike told me later, his blood was spilling.”

  From Milken’s standpoint, however, it was all for the usual good cause. Less than six months later, he was raising $3.5 billion for GAF’s bid for Union Carbide, and by that time Milken had achieved his accustomed bargaining position: on top. For this amount of money, in a hostile bid, Heyman had nowhere else to turn. And though Heyman fought hard with Milken’s assistant, Peter Ackerman (Milken remained characteristically above the fray), in the end Heyman had to agree that in the event GAF did acquire Union Carbide, not only would the refinancings and some of the divestitures have flowed in a golden flux through Drexel, but Drexel would also receive (ostensibly to distribute to the bond buyers, but maybe to keep for Drexel) 15 percent of the equity in the newly constituted company.

  By 1986, when “merchant banking” arrived as the new craze on Wall Street, Drexel had already amassed equity stakes in more than 150 companies. Milken had had the principal mentality from his earliest days as a trader, and the firm had followed his lead. It had become partners with many of its clients. This approach suited Milken especially, because not only did it mean sharing in the upside of the companies he was backing, but it augmented his control. With Milken and his group owning a sizable chunk of a company’s stock—and being just a few phone calls away from amassing a much larger block—the chairman of that company would tend to be pliant.

  Drexel had started demanding its pound of flesh in equity back in the late seventies, when the firm sought warrants as well as fees in its junk-bond underwritings. But its amassing of equity took a quantum leap as Drexel moved into financing leveraged buyouts in 1983–84, and then the hostile LBOs, or takeovers. The equity in these deals is, of course, where the massive upside potential lies. And Drexel typically demanded warrants (to purchase the stock cheap) as equity kickers to help sell the bonds. It seems, however, that much of that equity never reached the bond buyers.

  Richard Cashin, of Citicorp Ventures, who has worked with Drexel on a number of LBOs, said, “Drexel was developing a clientele in these deals that was rate-oriented, like mutual funds.
So Drexel would sell them the bond, maybe at a discount—and Drexel would keep the equity. They would say, ‘The buyers need the equity.’ Well, Drexel needs the equity.

  “A lot of the bonds are done on swaps—Drexel will give someone a Levitz bond for a Safeway. It’s so Byzantine, you never know how much the trade was, where the equity has really gone. They register the equity in Street names out in L.A.

  “In Levitz,” Cashin continued, “they said, ‘The bond buyers need the equity.’ Then we find out, who has the equity? It’s Drexel. It’s a movie, you’ve seen it a hundred times before, you could cut it short but you don’t. Look, we’re Citibank—it’s crazy for us to go on bended knee to L.A. But we do. Because we find they’re very smart and they benefit fifteen ways to Sunday, but they do what they say they’re going to do and they get the deal to close.”

  One former Drexel employee confirmed Cashin’s view. “In a buyout, Mike’s guys might say, ‘OK, we need twenty-five percent of the equity in order to sell the debt.’ But then it never goes to the bond buyers. Mike’s salesmen know their accounts, they can say, ‘Buy this,’ and they will. And the buyers don’t even know that the warrants are available.”

  As the competition with rival firms intensified and the options of clients grew—especially prospective clients, not already wedded to Milken—he encountered some resistance. In one instance in early 1985, Merrill Lynch offered to do an offering of about $200 million of preferred stock at 14.5–14.75 percent (depending on the market at the time of pricing) for Home Insurance. Hearing about the deal, Drexel quickly offered to do $250 million at 14 percent. “We had the order and were writing the prospectus, but George Schaffenberger [then chairman of Home Insurance] said, ‘I have to give Drexel a chance,’ ” recalled a Merrill investment banker. “They came back with American Financial [owned by Carl Lindner] as the buyer for the whole thing—and they were demanding warrants for twenty to twenty-five percent of the company. George told them to stick it.” Merrill did the offering, raising $285 million, at 14.75 percent.