Business: The Incredible Bond Machine


To critics, it's the "Predators' Ball" or the annual "junk bond" conference. Officially, it was Drexel Burnham Lambert's 11th Annual Institutional Research Conference, held April 5–8 at the Los Angeles Beverly Hilton. For three and a half days, 3,000 buyers and sellers of high-yield bonds were regaled with presentations by Drexel clients, fast-paced videos on the "high-yield world," lectures from professors, talks by celebrities, rock music, and glitzy entertainment.

The annual conference was the creation of Michael Milken. But for the first time, the mastermind of the high-yield revolution was not present. It was only coincidence, perhaps, but the federal government chose to indict Milken on March 29. Under Drexel's plea bargain with the feds, Milken was put on unpaid leave the moment he was indicted. And, company lawyers apparently decided, that meant he could not deliver his customary keynote address or even set foot inside the hotel. As icing on the cake, the feds scheduled Milken's arraignment for Friday, April 7—in New York.

Nevertheless, his presence was very much in evidence throughout the conference. Drexel officials, from CEO Frederick Joseph on down, praised Milken's genius and regretted his absence. Cofounder "Tubby" Burnham, complaining that company lawyers had "destroyed" his speech, said he's had to endure the last two years in silence. But he stated flatly: "I'm proud to have hired Mike Milken. I regret very much that he can't be here." A three-minute "Milken Rap" video—and much applause—followed.

As for Milken's whopping compensation—reportedly some $1.1 billion in salary and bonuses over the past four years—Burnham had a simple reply: "We believe in incentives." The next day, outgoing chairman Robert Linton, who stressed that he had not checked this out with his lawyers, also defended Milken's compensation. IBM lost Ross Perot as a salesman because they would not adequately reward his achievements, said Linton; likewise, dealmakers Kohlberg, Kravis, and Roberts are now in business for themselves (as KKR) instead of for Bear, Steams, to the latter's great loss. Boone Pickens had the last word about Milken's compensation. "Who is it that's griping about the fees? Nobody who paid them, including me."

Not everyone loves Mike Milken and the high-yield revolution in corporate finance that he and Drexel Burnham set off. Corporate restructuring has been labeled "paper entrepreneurship" by a wide range of critics, including academic leftists, neoliberals, CEOs of giant corporations, and even a number of conservatives. A recent subscription letter for left-wing Mother Jones magazine is fairly typical: "The current epidemic of corporate takeovers is gutting the American economy—costing us millions of jobs and billions of dollars in lost tax revenue." Conservative writer Ben Stein chimes in with the charge that whatever gains are achieved "come out of the hides of the laid-off, cutback and disenfranchised workers." The United Auto Workers has embarked on a major advertising campaign along similar lines.

This kind of rhetoric dominates mainstream news coverage of the subject. High-yield bonds are routinely described as "junk bonds." And a Los Angeles Times headline about the conference blared: "Raiders Pay Homage to Milken"—as if high-yield bond buyers were synonymous with corporate raiders.

Not surprisingly, an underlying theme of the conference was an attempt to set the record straight. Making presentations at the conference, in addition to popular speakers such as Jaime Escalante, George Gilder, Peter Grace, and Art Laffer, were academic experts on finance and corporate structure—people such as Harvard Business School's Michael Jensen and the University of Rochester's Gregg Jerrell, formerly chief economist at the SEC. They and their colleagues reviewed empirical findings on the effects of the high-yield revolution.

For example, contrary to popular perception, most "junk bonds" have not been deployed in hostile takeovers. Between 1980 and 1988, unsolicited takeovers accounted for only 5 percent of the dollar value of new high-yield bonds. Most of the money—59 percent—was poured into companies' internal growth and development. The remaining 36 percent was used for various kinds of restructurings: mergers and friendly acquisitions, leveraged buyouts, or refinancing.

Nor has this saddled American corporations with unprecedented and dangerously high debt levels. Some firms have dramatically increased their ratio of debt to equity; but overall, corporate debt is a smaller fraction of total capital than in the 1970s. In part, this is because of a $2-trillion increase in the value of corporate equity since 1970—an increase that coincides with extensive corporate restructuring aided by high-yield finance.

This wave of restructuring has now been subjected to empirical research. The results are perhaps counterintuitive—and certainly counter to the popular view of ruin caused by greedy "paper entrepreneurs."

Looking at a sample of 43 large leveraged buyouts (LBOs) from 1984 to '86, economist Glenn Yago checked out corporate performance for at least two years before and after the LBO. He and his colleagues found substantial gains in total sales, sales per employee, operating income, and capital spending following the buyout. Although the parent company eliminated some positions as units were spun off, overall the LBOs reversed what had been a pattern of job loss in these companies.

What about R&D? A common criticism of LBOs is that the new managers will slash research and development, ignoring the future in order to cover huge new interest payments. But Steve Kaplan at Harvard and Abbie Smith at Chicago have found that very few of the firms involved in LBOs even do R&D (or enough of it to show up in financial statistics). On the other hand, they consistently increased capital spending following the LBO. These companies do not seem to be "mortgaging their future."

Harvard's Michael Jensen, probably the guru of corporate restructuring scholars, has found that the market value of companies taken over between 1975 and 1986 increased by $400 billion! This is not because shareholders are stupid. They put higher values on the restructured companies because the makeovers increase productivity. A major reason: the owners and the managers of the restructured firms are substantially the same people. Their major equity stake—averaging 60 percent—offers them a chance to make piles of money if the company does well (or to lose it all if it fails).

By contrast, traditional corporate management, with its separation of ownership and control, is a creation of the New Deal. Legislation of the era put major restrictions on investment and ownership by banks and financiers such as J.P. Morgan—whom Jensen terms "active investors." But the withdrawal of active investors left corporate management virtually unmonitored for 50 years, with very little penalty for wasting resources and building unproductive empires. Milken, Drexel, and the other architects of the high-yield revolution have recreated the role of active investors—people like the Bass Brothers and the Pritzkers and Coniston Partners, who are both owners and managers.

Some 20 years ago, law professor and economist Henry Manne came up with the theoretical concept of a market for corporate control. What Michael Milken has done is make that market an everyday reality. Jensen and others now refer to mergers, tender offers, spin-offs, buybacks, and LBOs as "corporate control activities."

One of the largest and most-discussed LBOs is that of Beatrice in 1986. At the time of its takeover by KKR, Beatrice was the quintessential conglomerate: over 100 businesses—ranging from tomato sauce and orange juice to rental cars and bras. Each new acquisition had led to new layers of bureaucracy and central administration. Aided by $2.5 billion in high-yield bonds, the new team of active owners aimed at massively restructuring the company to concentrate on its core food businesses. They sold off units such as Avis, Playtex, and Tropicana, raising some $6.9 billion—and retiring nearly all of the new debt in less than three years. In addition, CEO Frederick Rentschler told the conference, they slashed bureaucracy (headquarters staff cut from 455 to 97) and reduced overhead from $150 million to just $30 million a year.

High-yield financiers don't just restructure through takeovers, however. Hundreds of troubled companies, thanks to Drexel and company, are restructuring themselves to survive and grow. Western Union, for years at death's door, is today a Drexel high-yield customer. Under a new management team, the company is more than a year into a corporate makeover that is shifting its business from telexes and telegrams (who sends them anymore?) into value-added services such as electronic mail. While the company is not yet in the black, CEO Robert Ammon's presentation made a convincing case that it has turned the corner.

But the majority of the dollars from high-yield bonds is used to expand existing, healthy companies, especially high-tech and service businesses that do not qualify as "investment-grade" and therefore cannot get conventional bond financing. Of all U.S. firms with $35 million or more in revenue, only about 1,100 are considered investment-grade by rating agencies such as Standard & Poor's. That leaves over 21,000 sizable companies unable to tap the conventional bond market. These businesses gross $2 trillion a year and employ 15 million people. They include many of America's fastest-growing companies and virtually all firms headed by women and minorities—a fact not lost on Drexel's PR people.

Here, too, the data show surprisingly strong results. Lilli Gordon of Analysis Group Inc. and Harvard's John Pound studied a sample of firms making high-yield offerings that were larger than $50 million and that increased the companies' long-term debt level (average increase: 565 percent!). Among the 32 companies were M/A Com, MCI Communications, KinderCare, and Mattel. Comparing the years before and after the debt issue, they found substantial increases—exceeding the expectations of securities analysts—in five performance measures: sales, cash flow, earnings, dividends, and capital spending.

Most interesting of all are investors' views. A company's price/earnings ratio is considered a measure of its future value. For these debt-issuing companies, investors bid up their prices in the subsequent year enough to double their P/E ratios. The market reading on the debt issue was unambiguously positive.

Milken made clear in a post-conference interview how strongly he believes in the "democratization of capital" brought about by high-yield finance. Conventional investment—in oil, S&Ls, the Fortune 500, and the Third World—managed to lose $2 trillion over the past two decades. At the same time, the 95 percent of America's businesses that are not investment-grade gained $2 trillion (as measured by the Wilshire 5000).

Critics such as Ben Stein are particularly off-base on the effects of the high-yield revolution. Attacking "junk bonds" in Barron's and The American Spectator, Stein ignores the empirical record and instead cites national data showing poor overall productivity growth and competitiveness in the past two decades. But aggregate figures are still dominated by the 5 percent of investment-grade companies—which account for 63 percent of all corporate revenues and 81 percent of all funds raised in the public debt market.

And that's not where all the new jobs are coming from. As Richard McKenzie observed in The Great American Job Machine, the U.S. economy has created some 37 million jobs since 1970. The Fortune 500 have been downsizing; it's the small and medium-size companies—Milken's kind of companies—that have been creating jobs. High-yield bonds opened up the public capital markets to precisely the companies that are creating jobs, making innovations, and increasing productivity: in high-tech, in services, and even in old-fashioned businesses such as steel, with minimills. Traditionalist critics are totally and completely wrong about what's really been happening.

Where does that leave Mike Milken, the architect of this revolution? Despite facing the threat of up to 520 years in prison and $1 billion in fines—for alleged instances of stock parking, stock manipulation, and insider trading—Milken has dug in for a fight to the finish. Drexel felt it had no choice under the RICO law's threat of asset confiscation, but Milken shows no willingness to cop a plea and settle with the feds.

And it may just be that in throwing the book at Milken, former U.S. Attorney Rudolph Giuliani and the feds have gone too far. Two days after the indictment, a full-page ad in major newspapers announced, "Mike Milken, we believe in you." The ad listed its 90 sponsors, all heads of firms that have done business with Drexel and Milken. Others have spoken out in letters to the editor, criticizing the media's treatment of Milken as if he were a criminal. Even Ted Turner, one of the few alleged victims listed in the indictment, was center-stage at the conference praising Milken.

Mike Milken as a new American folk hero? It's not often a billionaire, even a self-made one, captures the public's imagination. But Milken's story is that of the classic American entrepreneur: someone who figured out a new way to do something—and became fabulously rich in the process.

In R.W. Grant's 1964 poetic saga, Tom Smith and his Incredible Bread Machine, envy greets the inventor of a machine that makes bread for a penny a loaf, solving the world's hunger problem. Tom Smith is attacked and prosecuted as a monopolist and exploiter—and ultimately jailed for antitrust violations. The parallel was not lost on Drexel; the company gave a copy of the book to each of 3,000 conference attendees.

Whether Mike Milken is ultimately judged a hero or a villain will say much about American values as we enter the 1990s. There's a battle going on—between individualistic entrepreneurship and coercive redistributionism, between managed state capitalism and truly competitive capitalism. We say we need lean-and-mean companies that are fit to excel in a competitive world. Milken unleashed forces that are helping those very companies. Does America reward or punish such innovation? Stay tuned.

Robert W. Poole, Jr., is publisher of REASON and president of the Reason Foundation.