Predator's Ball

“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.”

“At most investment-banking firms, if they had filed to do a junk underwriting for $100 million but found they could sell only $50 million, they typically would cut the deal back to whatever they could sell. But Milken had for years now made it a point of honor that he would not cut back a deal. As he would testify with apparent pride in a deposition in mid-1986, “I would say also that in my entire career on Wall Street I have never backed out of a transaction once I’ve agreed to stand up to it, no matter how onerous it turned out to be.” This policy presumably sprang not only from Milken’s sense of probity, but from his knowing it was good for business. It was meant to—and generally did—incur a sense of deep indebtedness in the client. Marshall Cogen of General Felt Industries, for example, recalls that in the hard times of 1980 Drexel filed to raise $60 million for General Felt but found they could sell less than half of that; the firm took the rest. As Cogen said in an interview in 1986, “I have never seen that done by another investment banking firm—never. Today everyone wants to bank us—Goldman, Lazard. But no one else would have raised that money back in 1980. And without it I never could have developed the base I have.””

“Wynn concurred. “We symbolized, in terms of timing and our essential posture, the archtruth of Drexel’s philosophy. There we were, wanting more money than anyone could argue we had a right to. It was venture capital, masquerading as debt finance,” he concluded, capturing the essence of Milken’s operation.”

“NELSON PELTZ went through the four days of the Predators’ Ball, as he would later say, as a “nervous wreck.” Peltz, who had a track record in business that can be described as lackluster, saw National Can as the opportunity of a lifetime. He had run his family’s frozen-food business, expanding it through acquisitions and then selling it in the midseventies; it later went bankrupt. Peltz had struggled for years, been close to broke, finally managed in 1982 to acquire with Peter May a controlling block of Triangle Industries, which he intended to leverage up as his vehicle for acquisitions. Until now, nothing had worked. And he”

“Milken does not run with the herd. He is, said Joseph, “one of the greatest natural contra-thinkers I’ve ever seen. If you say, ‘It’s a nice day,’ he thinks about the fact that people think it’s a nice day, maybe it’s not nice somewhere else, maybe it’s not gonna be nice, compared to what, what do you mean, nice day? He really thinks that way. That is perfect for an investor, or a trader, to be a contra-thinker. It turns out it is perfect for a finance business, trying to figure out what’s going to happen in the future.””

“Milken would in effect create his own firm within the firm of Drexel Burnham, one which its members would refer to simply as “the Department.” He laid the groundwork for that autonomy in 1973. From the very beginning, Milken made it mandatory that a certain portion of his people’s profits were reinvested in trading accounts which he ran. It was a system of forced savings, in which these salesmen and traders were able to watch—from a distance—their wealth accumulate. With the kind of return Milken got, no one really had much to complain about. On the other hand, if one decided to leave him on less than amicable terms, as one trader would, there might be difficulty in getting one’s money out. It was a powerful disincentive to taking any secrets from Milken’s operation to a rival firm.”

“The difference in the attitudes of those who were owners and those who only felt like employees was clear to him. “If you get a guy with some of his money in a company, he’s going to do better than people who are getting a salary and bonus based on the size of the company,” declared Joseph, delivering the Drexel exegesis. “. . . We wanted to finance companies of the future by picking guys who were going to be successful entrepreneurs, and our main discipline was getting them to have their money in the company. And we insisted on it.””

“Drexel clients—in addition to Triangle Industries—would make bids for companies, all backed by Milken’s junk bonds. Mesa Petroleum, with a net worth of $500 million, would go for Unocal. Lorimar, with a net worth of $105 million, would offer $1 billion for Multimedia. Sir James Goldsmith would make a bid for Crown Zellerbach Corporation for $1.1 billion. Golden Nugget, with a net worth of $230 million, would go for Hilton Hotels for about $1.8 billion. And Farley Industries, with earnings of $6 million, would go for Northwest Industries, for about $1.4 billion. Other bids would take longer to germinate—but they would turn out to be the most fruitful of all.”

“Because of their small size, or their lack of credit history, or their leveraged capital structure, these companies had been rated below investment grade by the rating agencies and thus had not been able to raise money by issuing bonds in the public market. The only way for them to borrow money was in short-term loans from banks or in private placements with insurance companies, which carried covenants so restrictive that they made the money almost not worth having.”

“W. Braddock Hickman in his enormous multivolume tome Corporate Bond Quality and Investor Experience,”

“T. Boone Pickens, Carl Icahn, Irwin Jacobs, Sir James Goldsmith, Oscar Wyatt, Saul Steinberg, Ivan Boesky, Carl Lindner, the Belzbergs—and lesser lights about to shine, such as Nelson Peltz, Ronald Perelman, William Farley.”

“RONALD PERELMAN brought more to the party than Peltz did. Perelman, for whom Drexel had been doing junk-bond financings since 1980, had boot-strapped himself into a series of acquisitions—keeping the profitable core, selling off the pieces, paying down the debt and leveraging up for the next acquisition. They were small by Drexel’s new standards—who had ever heard of Ronald Perelman in 1985?—but at least they had worked. With Drexel’s assistance, Perelman had just taken private his mini-conglomerate, MacAndrews and Forbes. And he was in the process of acquiring Pantry Pride, a supermarket chain discharged from Chapter 11 bankruptcy reorganization in 1981, which had a huge tax-loss carryforward of over $300 million that could be used to shelter income. It would be his vehicle, he hoped, for the kind of acquisition exponentially bigger than anything he had attempted before, something that would vault him forever out of the minor leagues. For the last month or so, Perelman, a crude Napoleonic type who was drawn to glamour and status, both in companies and on the social scene, had been eyeing Revlon. At the conference, Milken and Perelman had agreed that when the Pantry Pride deal closed, Milken would raise about $350 million for that company in a “blind pool”—for the purpose of an acquisition, but with no target identified.”

““Mike’s difficulty, gigantic, was that he simply didn’t have the patience to listen to another point of view,” this former executive continued. “He would assume he had conquered the problem and go forward. He was useless in a committee, in any situation that called for a group decision. He only cared about bringing the truth. If Mike hadn’t gone into the securities business, he could have led a religious revival movement.””

“The universe of corporate bonds that Milken was entering consisted mainly of “straight debt”—bonds whose holders receive fixed-interest payments, typically every six months, until maturity, when the interest is repaid. A much smaller, more arcane part of the market consisted of convertible debt—bonds whose holders have the option to exchange them for other securities, usually stock. Corporate bonds are rated by rating agencies, such as Standard and Poor’s and Moody’s. Those companies with the strongest balance sheets and credit history, the elite of corporate America, are rated triple A. When they issue bonds in order to raise debt capital, the interest those bonds pay is not much higher than that of risk-free U.S. Treasury bonds. These are known as “investment-grade” companies.”

“Milken encountered the Hickman study while he was at Berkeley. W. Braddock Hickman, after studying data on corporate bond performance from 1900 to 1943, had found that a low-grade bond portfolio, if very large, well diversified and held over a long period of time, was a higher-yielding investment than a high-grade portfolio. Although the low-grade portfolio suffered more defaults than the high-grade, the high yields that were realized overall more than compensated for the losses. Hickman’s findings were updated by T. R. Atkinson in a study covering 1944–65. It was empirical fact: the reward outweighed the risk.”

“Milken found his métier researching and trading these bonds. First he learned everything he could about the companies whose bonds he would be trading, preparing for his hours on the trading desk as though it were orals. Then he was ready to make his bet.”

““The opportunity to be true to yourself in high-yield bonds is great. It is not like buying a stock. With a stock, its value is generally dependent upon investors’ collective perceptions of the future. No matter how much research you have done regarding a particular stock, you don’t have a contract as to what the future price will be. But with a high-yield bond there is a date certain in the future when it matures, and if you hold it to maturity and your analysis is correct, you will be correct in your calculation of your yield—and you do have a contract as to future price. One is certain if you’re right. The other is not.””

“Lindner and Steinberg—who is about twenty years younger than Lindner—had followed somewhat similar career paths. Both were outsiders, who had amassed their own fortunes, and who had forever alienated the establishment with their onslaughts on major banks. And both acquired property- and casualty-insurance companies which would assume significant stock positions (in Steinberg’s case, sometimes with hostile intent) in other major companies.”

“Steinberg had started a computer-leasing business, Leasco, when he was just a couple of years out of Wharton, in 1961. That very profitable company’s stock had soared in the heady stock market days of the late sixties, making it possible for little Leasco to take over the conservative, 150-year-old Reliance Insurance Company, nearly ten times its size, by tendering to its shareholders a package of the highly valued Leasco paper.”

“An Israeli emigrant, Riklis had started out with a stake of just $25,000, buying and combining small companies in the 1950s. By the time he met Milken in about 1970, Riklis controlled a conglomerate, Rapid-American, which had sales of close to $2 billion. It included such companies as International Playtex, Schenley Industries, Lerner Shops and RKO–Stanley Warner Theatres. What Riklis had done was acquire one company and then use its assets to acquire the next, and that company’s to acquire the next, in ever larger circles. He acquired these companies by issuing mainly bonds, or debt, in exchange for the company’s stock. As Riklis liked to say, Rapid-American owed its success to “the effective nonuse of cash.””

“The major difference between Riklis’ debt-laden acquisitions and those of Milken’s later acquirers was that Milken’s chosen would issue the bonds for cash and then give the cash to the shareholders, while Riklis would issue the bonds directly to the shareholders. Both Riklis and his successors a generation later, however, would be using to their advantage the same debt-favoring provision of the U.S. tax laws: interest (on bonds) is deductible, but dividends (on stock) are not. Therefore, assuming roughly a 50 percent corporate-income-tax rate, a company that can pay shareholders a rate of return of 7 percent on dividends can just as easily pay 14 percent interest on subordinated debt, because it can deduct the interest.”

“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.”

“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.””

“One of Gobhai’s key premises is that most great ideas are, as he says, “born bad”—by which he means that one is more likely to make one’s way to the great idea from the seemingly crazy or outrageous than from the cautious and sensible.”

“Gobhai, who encourages the use of metaphor and animal imagery in his groups, recalled that someone in the room put forth the idea that most investment-banking firms functioned as a pride of lions, in which the male lions (the investment bankers) ate their fill first, and then the remains of the kill came down the line (to the traders, the salesmen and the research people). What they ought to do at Drexel, someone else ventured, was function as a wolf pack, with all of them bringing down the kill and all eating together. Put more directly, Milken and his group should not have the lion’s share. There could be no question of these investment bankers having the lion’s share in the traditional mode, since Milken was the engine that empowered them. He needed the product they brought him, it was true; but he could replace them in a moment. They could not replace him. But should they be more like him, should they (to adopt the metaphor) run with his pack? Traders typically had a principal mentality (often using the firm’s capital to take positions), whereas investment bankers tended to have an agent mentality (facilitating transactions on behalf of a client, who was in turn the principal). Milken had a principal mentality with a vengeance. He invested not only the firm’s capital but his own and his people’s profits. At this point, he was buying the bonds of bankrupt or near-bankrupt companies, at enormous discounts, and investing in some venture-capital deals. While his partners in corporate finance did not know just how much money Milken and his associates were making in these trading and investment partnerships, they rightly surmised that it was a king’s ransom next to their own incomes (which in 1978 were under $100,000 a year).”

“Drexel became a pioneer in what Wall Street would by the mideighties loftily call merchant banking (a term borrowed from the British), which simply meant that a firm was using its own capital to finance deals (as a debt and/or equity participant).”

“By 1980, soaring interest rates were already causing bondholders to suffer. So, in order to keep luring bond buyers into the market, Milken and Joseph came up with newfangled pieces of paper over the next several years. High-coupon, high-premium convertible bonds (if the related common stock declined, the high yield would offer significant downside protection). Bonds with warrants. Commodity-related bonds: four were exchangeable into silver, one into gold, two had returns related to the price of oil, and one had a coupon which would increase based on the volume of trading on the New York Stock Exchange.”

““I used to sit with a company and say, ‘What do you want?’ ” Joseph recalled. “I’ve got to give the investor the potential to earn the return that he thinks is fair for this package. But I can give him the return any way I want. I can give it to him by giving the money back sooner, or by giving him a higher interest rate, or by giving him more stock, or the stock cheaper. “ ‘Tell me the one thing that’s the least important to you, and if you give me control of one variable, there’s nothing we can’t do.’”

“the accountability factor to his entrepreneurial system of compensation in corporate finance. “More than most other firms, we understand that we’re a middleman in the marketplace,” Joseph claimed. “We have clients on both sides. And because Mike is so powerful, we have really been serious about that ongoing responsibility to buyers. It is a long-term approach to your business, instead of just do the deal, get the fee and get out of there. “If you do a deal here that goes bad, we’re the only firm that keeps you accountable down the road. You’ve gotta fix it. If you don’t try to fix it, I’ll kill you. If you try to fix it and do fix it, you’ll almost recover the ding. If you try to fix it real hard and don’t, you’ll recover some.””

“Milken’s theory was that many companies don’t go broke on the operating-profit line; rather, it is often financial charges that kill them. If there were a way of reducing or removing those charges, these companies might survive and ultimately return to health. Drexel investment banker Paul Levy, who would come to specialize in this area, stated that its key is the concept of the “flexible balance sheet,” or adapting to a company’s changing needs. If a company is being choked by its interest-payment obligations, why not make those payments in common stock? Or why not just exchange the old debt paper for common stock, and eliminate the charges entirely? In this new-age finance, nothing is written in stone. “People used to issue bonds, and after twenty years they would repay them,” Levy said. “That’s hogwash!” The bondholders would tend to accept these offers, no matter how displeasing, because they would find themselves between the proverbial rock and a hard place. As Levy explained, these exchange offers are essentially an arbitrage. If a buyer purchased at par a bond which then came to trade at sixty cents on the dollar, he would probably be willing to exchange it for a piece of paper trading at sixty-five cents—especially if he thought his alternative was to be stuck holding the bonds of a bankrupt company.”

“Gary Winnick, Peter Ackerman, Dort Cameron, Charles Causey”

“As though to underline this desire for structural egalitarianism, Milken had no office. On the infrequent occasions when he was away from his desk in the center of the trading floor, he urged others to use it. Meetings were generally open to all who were interested. People were encouraged to perform numerous functions. In a later SEC deposition, given in 1982, Milken described some people in his group as “quasi-trader salesmen,” explaining that “on a given day he could be primarily selling, and another day he could be trading. Another day he could be doing something else.””

““I would say there is no second in command. You could say on some days there’s one hundred seventy people that are second in command, and other days, you know, there’s ten. It depends on what’s happening, what the situation is. People have responsibilities, rather than a formal organization chart.””

“Milken kept his group cloistered. He demanded that his people shun publicity, as he did. He was convinced there was no upside—“Mike would always say, ‘You can’t make a dime off publicity,’ ” Steve Wynn recalled—and there was considerable downside. If his people started seeing themselves in print, he once commented to this reporter, they would get their heads turned, they would think they were famous. “They won’t work as well. I want them there at four or four-thirty, ready to work, until eight o’clock at night. That’s what we do, that’s our responsibility. I don’t want them to think of what’s outside.””

“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.”

“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.”

““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 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.””

“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.”