The Predators’ Ball (14 page)

What set First Executive and Columbia apart from other institutions and companies with which Milken was playing his multiplicitous roles by 1983 was the degree of their metamorphosis. Others had benefited from Milken's performance, but they had not been so utterly transformed from flounderers to titans—and titans whose sustenance, in large part, continued to come directly from Milken. The bigger their appetites for junk became, the more useful First Executive and Columbia would be—ultimately functioning as enormous appendages of Milken.

For the moment, in 1983, Carr and Spiegel performed their functions in Milken's machine by joining the other members of Milken's extended business family—including Carl Lindner through American Financial, Saul Steinberg through Reliance Insurance, Meshulam Riklis through Rapid-American, Victor Posner through several of his companies, the Belzbergs through a number of their companies, and others—who issued their own paper and bought one another's and traded, with Milken the nexus for it all.

But as important as these players were, by year-end 1983 the junk market was far broader and deeper than Milken's coterie of high-rollers. From 1977 to 1983, 225 industrial and finance companies issued approximately $19.5 billion of junk debt. According to Milken's estimate, by the end of 1983 the junk market totaled over $40 billion par value (including those issues which had been downgraded into the junk category, as well as originally issued junk). And since the entire straight corporate-bond market was about $375 billion, the junk sector was roughly 13 percent of the total.

Even as this market won more and more buyers—or, in Milken's
lexicon, “disciples”—it still was not a mainstream kind of investment, so the yield spreads remained impressive. At the end of 1983, Milken estimated that for several years the typical high-yield bond had outyielded long-term U.S. Treasury bonds by 300–500 basis points (paying 13–15 percent, compared to a 10 percent yield from a Treasury bond).

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 fever, 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.