Venture Capital Masquerading as Debt

"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."

"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."

"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."