Gekko Echo

A closer look at the "Decade of Greed"

David Kelley & Jeff Scott from the February 1993 issue

(Page 2 of 4)

Other innovations in capital markets broke down the traditional segmentation among firms. Large creditworthy borrowers could go directly to the market to issue commercial paper; they no longer needed the banks as intermediaries. In the mortgage market, the rationale for savings and-loan institutions was disappearing. Mortgage bankers and other sorts of finance companies could originate loans, credit agencies could guarantee them, and mutual funds could hold them by buying mortgage-backed securities, a product pioneered by Salomon Brothers in the early ‘80s. It turned out that these functions do not need to be bundled together in a single firm; unbundling them allowed more competition and lower mortgage costs for consumers. In addition, new techniques for balancing debt/equity ratios. selecting market portfolios, and pricing undervalued asset; revolutionized corporate finance and securities trading.

These innovations made a great deal of money for those who invented, developed, and took advantage of them, with the greatest profits typically going to those with the vision and courage to get in early. The profits were a fair return for the creation of value: The innovations lowered costs, improved efficiency, saved time.

The same is true for the two most controversial innovations of the ‘80s: leveraged buyouts and junk bonds. There is now an extensive body of academic research on both phenomena, and the conclusions are diametrically opposed to the popular impression.

In a typical LBO, a corporation would be taken private by top management working with a pool of investors led by a buyout firm. These investors would purchase all outstanding shares of the company, putting up 5 percent to 10 percent of the purchase price from their own money and borrowing the rest. After the buyout, management held a much higher share of the equity than before. With that incentive, along with "the discipline of debt," management would slash costs and sell off unprofitable pieces of the business in order to reduce the debt load and maximize the value of the equity. In a few years the company could be taken public again, usually at an enormous profit.

The source of these profits was the fact that many companies had developed a sizable paunch as a result of a breach between ownership and control–a breach that was largely the product of government regulations. Control over a company’s management must come either from those who hold its equity or from those who lend it money. In the postwar period, equity was dispersed among large numbers of shareholders, whose only real instrument for control was the freedom to sell their stocks. Debt levels were low, and in any case commercial and investment banks were largely prevented by law from having seats on boards of directors and exerting the kind of control they had in the days of J. P. Morgan.

Because of the low debt levels, many companies had large cash flows available after meeting interest payments, especially in mature industries that did not require large expenditures on research and development. Because of weak controls, management had considerable discretion over the use of free cash flows. Corporations tended to develop large bureaucracies, filled with unnecessary vice presidents. Top executives enjoyed excessive perks; among many egregious examples was Unocal CEO Fred Hartley, who had a grand piano installed on his corporate jet.

Finally, during the ‘60s and ‘70s, large corporations embarked on a wave of acquisitions, diversifying into fields unrelated to their core businesses and producing unwieldy conglomerates.

A measure of the fat that was padding the corporate frame is that buyouts occurred at an average premium of 50 percent above the market price of the stock, suggesting that unmonitored management was wasting up to a third of the value of corporate assets. Buyout firms such as Kohlberg Kravis Roberts earned enormous profits by recovering that value. To begin with, they restored the connection between ownership and control; as active investors, they monitored the performance of management. They realigned incentives by requiring that managers put a significant amount of their own money into the company and tying their compensation to the company’s performance.

By taking apart the conglomerates that had been built up over the previous two decades–a strategy often denounced as the "bust-up" philosophy–LBOs tended to produce more-focused and better-run companies. In 1986, KKR invested $407 million of its own money in the purchase of Beatrice Cos., the Chicago conglomerate that owned Avis, Tropicana, Playtex, and numerous other consumer-product divisions. Over the next four years, the firm took in $2.2 billion from the sale of these units to other corporations or buyout firms that could run them more profitably.

Perhaps most importantly, buyouts freed up vast amounts of capital that had been locked inside mature industries and resumed it to the market, where it could be invested in new and developing industries. Michael Jensen, a Harvard Business School professor and pioneer in the study of LBOs, writes that "the most careful academic research strongly suggests that takeovers–along with leveraged restructurings prompted by the threat of takeover–have generated large gains for shareholders and for the economy as a whole. My estimates indicate that over the 14-yearperiodfrom 1976 to 1990,the$1.8trillion of corporate control transactions–that is, mergers, tender offers, divestitures, and LBOs–created over $650 billion in value for selling-firm shareholders." As against this enormous gain, Jensen estimates that losses to bondholders and banks do not exceed $50 billion.

The same research has also refuted many other claims about buyouts. In early 1989, Lane Kirkland, head of the AFL-CIO, asserted that takeovers had eliminated 90,000 union jobs. No evidence has ever been found to support the claim; although middle-management positions were eliminated when corporate hierarchies were flattened, the buyout movement as a whole does not appear to have produced any net loss of blue-collar jobs. Companies such as Kraft and National Can preserved jobs at plants that would otherwise have closed. After the $4.2-billion buyout of Safeway Stores, a number of its unprofitable supermarkets were closed or sold, and in some areas where the company was competing with nonunionized stores, it won wage concessions from its unions. When the leaner and more productive company went public again in 1990, however, it announced a $3.2-billion expansion program.

Buyouts did produce some failures, especially toward the end of the decade, when deals tended to be more speculative. An example is the empire that Robert Campeau assembled by buying department stores such as Bloomingdale’s; Campeau filed for bankruptcy in early 1990 with $6 billion in debts. But even in this period, bankruptcy was not the norm. In the largest LBO ever, I the 1989 takeover of RJR-Nabisco by KKR, existing share-holders received $12 billion as a premium over the previous market valuation of the stock. During the next two years, under new management installed by KKR, the company reduced its debt load, improved operating efficiency, and created another $5 billion in value for its post-buyout owners.

Many acquisitions in the ‘80s were financed in part with junk bonds. In the latter half of the decade, Kohlberg Kravis Roberts was the largest client of Drexel’s High-Yield Bond Department. But the role of junk bonds was considerably less than the press, or the outraged CEOs of companies under siege, would lead one to expect. Glenn Yago, director of the Economic Research Bureau at the State University of New York, Stonybrook, has found that only 22 percent of the proceeds from high-yield issues during 1980-86 were used for acquisitions, and only 3 percent for hostile takeovers. Most junk debt was used for internal investment and expansion by entrepreneurial firms in new and growing industries: cable television, telephones, health care, home building, and many others.

Prior to the ‘70s, institutional investors such as insurance companies and pension funds would invest only in bonds with investment-grade ratings from Moody’s or Standard and Poor’s, a status restricted to about 800 corporations. Scholars in the 1940s had noticed, however, that the higher risk of default on non-investment-grade bonds was outweighed by the higher interest they paid; hence a portfolio of such bonds would outperform a portfolio of investment-grade bonds. As a student at the Wharton School, Michael Milken carried this analysis forward to the ‘70s and found that the gap had widened. When he went to work at Drexel, he began trading high-yield bonds with enormous success. The high-yield market in those years consisted of "fallen angels": bonds that had been issued as investment grade but had been downgraded. Milken helped create a liquid market for investors who wanted higher returns.

In 1977, he began underwriting new high-yield bonds, opening up the bond market to the 95 percent of firms that did not have investment-grade ratings. Over the next decade, Milken raised funds for more than 1,000 such companies, including MCI, Ted Turner’s CNN, and scores of others that have since become industrial giants. More than with any of the other innovations, the value created by high-yield financing can be credited to a single man. Milken’s success was the result of looking not only at the balance sheet but at the vision of the entrepreneurs, the intellectual and spiritual capital they had invested in the firm. "The value o a company and a business," Milken said, "is the knowledge