The 1980s junk bond and LBO boom 3 comments

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Michael Milken and Drexel Burham Lambert may be strange names to newcomers to the investing scene but in the 1980s they were at the centre of Wall Street when takeovers via leveraged buyouts (LBOs) were the rage. The former was the star junk bond dealmaker for Drexel and was hailed as the successor to Pierpont Morgan as a leader of Wall Street.

In the early 1980s, the US was emerging from a decade-long bear market characterised by surging annual inflation rates of >10%. The Federal Reserve under Paul Volcker took decisive action through raising interest rates to sky-high levels (long-term bonds had yields of >15% by 1981); by 1982 the inflation situation was under control and the Fed started lowering rates. The stock market had stagnated and having reached ridiculously cheap valuations, started to bottom out. It was in this capital market macro environment of undervalued market capitalisations (low stock prices) and declining interest rates (falling bond yields) that eagle-eyed investment professionals saw the potential for LBOs.

What are LBOs/leveraged buyouts? It is basically taking over a listed company using a combination of equity and debt, the financing structure being weighted heavily (say about 1:10 at least) towards the latter. It is similar to purchasing shares on margin: the speculator expands his investable capital through margin debt on an equity base (down here, usually equity must be >40% of total purchase at any time, I believe). LBOs are a much larger scale of such margin financing, using far higher margins, and yet having the advantage that the LBO participant is not subject to margin calls, and is not personally responsible for the LBO debt (to be explained below); ie. limited risk, high potential return. What's new: scale and big money talk on Wall Street.

It may be argued that LBO fever first set in through a demonstration of its potential in a wildly successful deal by former Treasury Secretary William Simon in 1983. He had participated in an LBO takeover of Gibson Greeting Cards which was financed by $1M in equity and $79M in debt (total purchase value $80M); 1.5 years later Gibson was refloated on the market for $300M. Simon's original investment of $330K (1/3 of the total equity stake) turned into a fortune of $66M (ie. 1/3 of the total market capitalisation), thanks to the power of 80:1 leverage.

The final piece in the jigsaw came with the arrival of junk bonds as the preferred debt financing instrument. As mentioned above, there was a need for transfer of the debt burden in LBO deals, and packaging out this debt in the form of junk bonds promising high yields to investors (usually institutional/high net-worth individuals), to be paid from future company cash flows, became a mainstream practice for LBO deals, thanks to the salesmanship of Drexel Burham Lambert and its star bond salesman Michael Milken. It would later be claimed that junk bond purchasers assumed most of the risk and "takeover entrepreneurs" took most of the reward. It certainly did not appear so at the onset (and certainly not when LBOs boomed in the mid-1980s) to the bond purchasers; what they saw were the high bond yields, not the risk of bond default.

LBO deals fluorished in the years 1984-89. Since leverage allowed limited equity capital to multiply its purchasing power manyfold, it was claimed that the playing field had been levelled, and that "the small can go after the big". Major LBO deals included the takeover of Revlon by Ron Perelman (he reportedly turned $2M equity into $3B over 10 years), multi-billion dollar takeovers by the LBO specialist partnership KKR of the conglomerates Beatrice and RJR Nabisco, and the capture of major department store chains Allied and Bloomingdale's by an eccentric Robert Campeau who used leverage on ratios ranging from 10 to 100; he even borrowed his equity portion from investment banks for the former's LBO takeover (to the banks, they didn't mind: they captured fees in the range of hundreds of millions for these LBO takeovers).

Since availability to capital no longer was a problem technically, relationships became a valuable tool. In particular, since Drexel Burham Lambert grew to command two-thirds of the junk bond market used to finance these deals, no-one could afford to antagonise them. Milken, in particular, commanded the financial and corporate worlds. And he leveraged (pardon the pun) this power well; he made astonishing cumulative earnings of $1.2B between 1985 and 1987. That is one hell of a salary, albeit commission-based.

The investment habits of the S&Ls (savings & loans funds, which take in small depositor funds and pay interest on them, something like our POSB) was a strong source of capital in purchasing the junk bonds, but their collapse in the late 1980s ultimately brought significant political attention to the pervading greed and declining deal quality in the junk bond market. In 1982 the Reagan administration deregulated the S&L industry, permitting them to source alternative funds (besides taking in deposits) and to diversify their portfolios (they had hitherto been solely providing home loans). The S&Ls' response was to expand capital exponentially by borrowing funds wholesale from Wall Street and using them to buy into risky high-return markets, in particular the emerging junk bonds market. When S&L fund managers' salaries are a function of the assets managed and the return of these assets, yet are unaffected by losses that result, this response was not surprising. By the end of the 1980s, as a result of such imprudent capital management the S&Ls had cumulatively lost about $200B, paid for by the government and ultimately therefore, the taxpayer.

Government scrutiny as a result of these market failures must have played an important part in Michael Milken and Drexel Burham Lambert being hauled up before court in 1988 for violating a series of securities laws, including racketeering, market manipulation, insider trading. There is no doubt that shady practices had been adopted in such LBO deals but as long as the market chugged along smoothly such practices might have been condoned; the laws were always on hand, however, to employ at the discretion of the government. The collapse of the S&Ls illustrated the declining quality of junk bonds in the late 1980s, with the decreasing spread between junk bond interest payments and LBO company earnings increasing the possibility of default (since interest payments were paid out of company profits). In 1989, following several junk bond defaults (including Campeau's holding company), the junk bond market went into a swoon, and Drexel Burham Lambert, with enormous junk bond holdings, became insolvent and filed for bankruptcy. Michael Milken himself was convicted, albeit for lesser offences than originally charged, in 1991. Over the early 1990s, the rate of default on junk bonds rose to around 9%, finally illustrating their highly speculative nature that had been obscured in the bond bull of the 1980s. LBO fever had subsided, and the junk bond market was effectively dead with its main evangelists removed.

When measuring the legacy of Michael Milken, one should not be overly critical. Although he ultimately inflated the market into a state of unreal speculation in junk bonds that steadily declined in quality, these junk bonds did provide useful financing for a host of other small non-LBO related firms with real need for capital, and helped them to grow. LBO deals themselves grew out of a market recognition that companies were basically undervalued on the stock market, and Milken's junk bonds arose out of a demand to finance such deals. Seen in this context, some argue that his accomplishments were positive and significant. Whatever the case, one need not worry for the financial state of the man; he is still among the wealthiest men on Earth as recently ranked by Forbes, with about $1B in assets.

References:
(1) Devil Take the Hindmost (by Edward Chancellor)
(2) Wikipedia entry: Michael Milken