“All in all, the 1980s are to debt what the 1960s were to sex.”
–James Grant
So as we pick up our story on Michael Milken, junk king, let”s
review the Leveraged Buyout (LBO) game that made Milken so
famous. The following is from Edward Chancellor”s “Devil Take
the Hindmost.”
“Although the Federal Reserve prevented speculators from buying
shares on a margin of more than 50 percent (still the case today),
there were no restrictions on the amount of leverage applied in a
buyout.”
“The participant in a leveraged buyout had several other
advantages over the margin speculator: his interest payments
were tax-deductible, he was not subject to margin calls, nor was
he personally responsible for the LBO debt, which was packaged
as bonds and sold on to other investors. If the company went
bankrupt he could walk away with little loss, but if the deal was a
success, his gains were outlandish.”
As Jim Grant also noted, “Milken understood, easy access to
credit facilitates the marginal transaction. It makes possible the
sale of the ”nth” product to the ”nth” buyer.but when the cycle
turns, the process must swing into reverse.”
The junk market was aided in 1982 by the Depository Institutions
Act, or Garn-St. Germaine Act, which allowed banks and savings
and loans to buy corporate bonds. [This was an expansion of an
earlier law passed in 1980.]
The savings & loans needed investments yielding more than their
traditional mortgages. Junk bonds fit the bill from the yield side,
quality was another matter.
Milken pursued his operations through a clique, whose
membership was far more exclusive than the so-called
establishment. By the time he got into the hostile takeover game,
he relied on a small number of corporate raiders, and sold to an
equally small number of institutional investors. Both sides trusted
him implicitly.
Last week we touched on some of the young and restructured
companies whose debt was underwritten by Drexel, like McCaw
Cellular and MCI. But out of the Mergers & Acquisition
department at Drexel came the idea of using junk to finance
leveraged takeovers of American public companies. Many of the
early targets were in the oil patch.
Back during the twin oil crises of the 1970s, the price of a barrel
of crude rose from about $3 to the mid-$30s but the stocks of the
major oil companies had not risen in a similar fashion. Fred
Joseph who had arrived at Drexel in 1974 and rose to become
head of the corporate-finance department, as well as a fast friend
of Milken”s recognized the opportunity. As corporate raiders
began to circle the oil companies, Joseph thought that Drexel
could capitalize on the situation by helping to finance some of the
raiders attempts. The theory is best described in Robert Sobel”s
book, “When Giants Stumble.”
“The method was simplicity itself. Take a company whose
breakup value was estimated at, say, $100 a share, whose stock
was selling for $40. The raider would offer the shareholders $60.
Management would protest that it was worth far more than that,
and the raider would shoot back that if this truly were so, then
management was admitting it had been doing a poor job. At the
end of the day the raider might obtain control of the company by
using borrowed funds to pay the shareholders. While doing this
he would have engaged the services of an investment bank, often
Drexel, but there were others, to arrange for permanent financing.
Milken and his team would then design a junk bond that would
appeal to Drexel”s long list of customers, often selling more
bonds than were needed, the idea being that the extra money
would be used to purchase bonds of other Drexel deals. In the
end the client would control a large company with a very large
debt. Assets might then be sold and the money thus obtained
used to repurchase the bonds, with substantial amounts left over
for the client.”
In August 1984, Milken and Drexel made their first move into the
field of hostile takeovers, backing T. Boone Pickens in his
attempt to take over Gulf Oil. The deal didn”t go through (Gulf
was acquired by Chevron) but aside from making Pickens a cool
$500 million on the bid, it established Milken as the most
powerful figure in finance.
Soon other deals followed, like in April 1985, when Milken-
backed raider, Nelson Peltz, acquired National Can in a $465
million deal, 11 parts debt to one part equity. Soon thereafter
Drexel client Ron Perelman acquired Revlon, in the largest LBO
to date. One year later, Kohlberg Kravis Roberts (KKR) raised
$6 billion through Drexel to take control of the conglomerate
Beatrice. [In this last deal, in addition to $50 million in fees,
Milken made another $250 million by acquiring warrants created
by KKR for him at a nominal sum and then later selling for 100
times their value.]
At the 1985 Drexel High Yield Conference, the “Predators Ball,”
Fred Joseph, now CEO, declared that “for the first time in history,
we”ve leveled the playing field. The small can go after the big.”
Such rhetoric was not just typical of Drexel but it was also
common among the raiders. They spoke of public service as
being behind their activities. [Think Gordon Gekko.] The
incumbent management was always inefficient and only concerned
with its own perks. [There is a lot of truth to this, to be discussed
more fully next week.] Nelson Peltz argued that “American
management was more Communist than the Russians.”
But most of the talk was like that of raider supreme, Sir James
Goldsmith, a real ass if there ever was one. “Takeovers are for
the public good but that”s not why I do it. I do it for the money.”
The raiders liked to talk about coming in and cutting costs after a
buyout. The management would be pruned and corporate
extravagance was to be curtailed. Au contraire. As former CEO
of Revlon, Michel Bergerac, observed, “These so-called raiders
manage to get hold of one of these large companies and a
mysterious process of osmosis seems to take place. They go to
London to get their suits, they have French chefs, they drink
French wine, one plane is not enough for them and some of them
have 2 or 3.”
And in the savings and loan arena, the extravagance was
legendary.
Thomas Spiegel, a former Drexel salesman, ran Columbia Savings
& Loan and was particularly close to Milken. Spiegel expanded
Columbia”s balance sheet to the point where it owned nearly $6
billion in junk. Columbia participated in all of Milken”s biggest
deals. Spiegel paid himself a $9 million salary in 1985 and
purchased 2 corporate jets.
David Paul ran Centrust Savings Bank of Miami. He bought $1.4
billion of junk bonds from Drexel which had earlier helped finance
his takeover of Centrust. Paul paid himself $16 million, spent
$1.4 million a year on a corporate jet, $13 million on a painting by
Rubens (at least he had good tastes) and $8 million on a yacht
(which had gold-leaf ceilings and a jacuzzi in the master suite).
And back to Milken”s web of clients. As an example, Edward
Chancellor described part of the S&L world.
“Southmark Corp., a conglomerate which issued junk through
Drexel, bought the San Jacinto S&L Assoc. of Houston in order
to finance real estate deals. (Southmark) became the landlord of
another of Milken”s clients, Circus Circus, a Las Vegas casino
operator. Southmark was connected with MDC Holdings of
Denver, which owned Silverado S&L and also issued junk bonds
through Drexel. McBirney”s Sunbelt Savings held Southmark
and MDC bonds in its junk bond portfolio.” And on and on.
[I am purposefully omitting discussion of Charles Keating and his
Lincoln S&L. Heck, I need to save material for later this year, let
alone 2004!]
And what about compensation? As I alluded to in one of the
earlier pieces on Milken, in the early 70s Milken negotiated a
generous package with Drexel, wherein he retained $1 for every 3
he made for the firm. He also ran a number of private investment
partnerships which participated in the more lucrative deals.
Reportedly he managed this money as if it was his own.
When Martin Siegel was interviewed for a position at Drexel,
Milken told him, “If people here know how rich they are, they”ll
get slow and fat. You must never count your money; you have to
keep driving yourself to make more.” Well, Milken made quite a
bit himself.
I have read different accounts of Milken”s own pay during his
hey day. Robert Sobel writes that Milken made the following:
$46 million in 1983, $124 million in 1984, $135 million in 1985,
$295 million in 1986 and $550 million in 1987. Others have
Milken making the $550 million in ”86 (obviously, the
discrepancy is over when the pay was earned vs. paid out). Still
other accounts have Milken making $1.2 billion, combined, for
the period between ”85 and ”87. Regardless, it is estimated by
many that by the time Milken left Drexel for minimum security
digs, he had accumulated a net worth of about $3 billion, which I
imagine bought him a lot of cigarettes and TV remote rights.
Next week, the fall of Michael Milken and a balanced appraisal of
his role in the financial history of America.
Sources: “The Great Game,” John Steele Gordon
“Wall Street: A History,” Charles Geisst
“When Giants Stumble,” Robert Sobel
“Devil Take the Hindmost,” Edward Chancellor
“The Book of Investing Wisdom,” Peter Krass
Brian Trumbore
