The Predators’ Ball (10 page)

Another former partner who refused the opportunity said he was disturbed by both the liability and the nondisclosure provision, which stipulated that the only individual to whom Milken would disclose his investments was Fred Joseph. “Here we would have this individual liability, which extended to the shirts on our backs, and Mike would not disclose to any of us what he was buying. It was weird.

“But most of those characters thought he was the Messiah,” this investment banker added. “The theory was that he could turn lead into gold.”

Investment banker Stanley Trottman put $100,000 into the partnership in 1981, and by the end of 1985 it had grown to $1 million. The partnership's return was rarely if ever less than 50 percent a year, and in 1985 it was close to 100 percent.

Given Milken's passion for secrecy, the firm that was being molded in his image could never become a public company. But in 1981 Tubby Burnham, who was at that time still the chairman of Drexel, brought the issue to debate. Milken, of course, was adamant. In a public firm he would never be able to run his trading partnerships for whomever he favored, never be able to build his own, autonomous shop based on them, never be able to keep secret what he was buying, what he was making, what he was sheltering. And some executives at the firm were also loath for the world to know what the profits of Milken's department were, compared to the rest of the firm's—since it would become clear, as one partner said, “that you could just take him out of the firm and have all its value.” Milken had his way, Burnham was, as he said, overruled, and the firm remained private.

I
T WAS AGGRAVATING
to some at Drexel—among them Robert Linton, who became president in 1977—that while Milken held magisterial sway over the firm, he chose to own none of its stock. Drexel was a firm that prided itself on its equity being broadly spread among its employees (unlike, for example, a firm such as Goldman, Sachs, which kept the ownership in the partnership very narrow). Indeed, given Milken's explicit conviction about the importance of feeling like an owner rather than an employee of one's business, and given his practice of accumulating equity stakes in scores of the companies he financed, it was utterly incongruous that he should refuse to own stock in Drexel. Linton is said by others at Drexel to have concluded that Milken's continuing refusal was evidence that the autocratic salesman-trader had no interest in the future of Drexel and was merely using it as his vehicle while it suited him.

Now Joseph persuaded Milken to make a show of good faith by taking some stock. Milken agreed, on the condition that the firm offer him a special issue—a bond with a warrant, a kind of hybrid convertible. Since this issue and a second issue several years later were made available only to Milken and some of his designated people in L.A., it became known within the firm as the “Western convertible.”

“Was a special deal created for Mike, different than for anybody else? Yes,” said Edwin Kantor. “Did he deserve it? Yes, again.”

Milken, of course, had not done this solely as a peacemaking
gesture. As one former member of his group explained, “Before that [Milken's taking stock], he just thought of it as a place where he had a nice deal. But by this time he saw that what he was creating was going to be unbelievable, and the profits were spilling over to the firm, in corporate finance and so forth. So why shouldn't he get his money both ways [in his percentage-of-profits deal and as an equity holder in the firm]?” He added that many members of Milken's group—who heretofore had not owned a significant stake in the firm—now followed Milken's lead. By 1986, Milken would be the firm's largest individual shareholder, owning about 6 percent of the firm's stock, according to an estimate in
Forbes.

B
Y
1980
THE
recession had hit, and Milken's business was especially vulnerable—for as interest rates skyrocketed, bond prices plummeted. But Milken was in his element. His friend Stephen Wynn asserted, “Mike does better in hard times than good. He goes hundreds of millions long. I remember I called him one day [in the early 1980s] and said, ‘How are you doing?' ‘Wonderful,' he said. ‘Down eleven million today, after sixteen million yesterday. I'm stuck for a hundred eighty million in all.' He was
cheerful.

“Mike knows the market is crazy, but it will come back,” Wynn continued. “But the people who run money panic, they want to get out, so they start selling everything—and Mike will make a bid. Then he sits there. And when it does come back, he makes out.”

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.”

In the early eighties, Milken took Drexel's junk-bond business characteristically against the current. While other investment-banking firms, some of which had been only gingerly testing the waters in junk, pulled back in the recession, Drexel kept pushing ahead, taking ever greater chunks of market share. In 1979 there were sixteen firms in addition to Drexel in the junk market; in 1980 that number dropped to twelve, and in 1981 to five. The total
amount of junk issued in these years did not vary that much, hovering between $1 billion and $1.5 billion—but Drexel came to be responsible for nearly all of it.

In 1979 the total issued was $1.22 billion, and Drexel had issued $408 million of it. By 1981, the total issued was $1.47 billion, and Drexel had issued $1.08 billion of that total. Drexel did twenty deals that year, and its closest competitor did three.

That competitor was Merrill Lynch—a firm that would try over the next two years to stay in the market and challenge Drexel's hegemony. By this time, Milken was already known for the ferocity with which he responded to challenges on what he viewed as
his
domain. And he and his crew responded to Merrill with the kinds of tactics that would ultimately make them hated by all their rivals on the Street.

Drexel and Merrill were co-managing a junk issue for Volt Information Services in 1981. Drexel arranged the road show that introduced the company's managers to prospective bond buyers. On the plane to Chicago the Merrill bankers found themselves in coach, while Drexel went first class with the Volt executives; and when they all arrived in Chicago, Drexel and Volt were in one hotel, Merrill in another. But the coup de grace came when the Merrill bankers arrived at the site of the road show and discovered—too late to notify their customers—that the location had been changed.

According to one Merrill Lynch banker, this was no anomaly but almost routine in the early eighties. “It got so that when we were co-managing a deal with Drexel and going to a road show, we always checked with their customers, to be sure that Drexel hadn't changed the location, at the last minute.” Drexel stopped this practice by 1984–85, he added.

Drexel's dominance was not founded on dirty tricks, only accompanied and perhaps protected by them. Fred Joseph emphasized that it was his and Milken's creativity that allowed them to keep doing so much junk business in the recession. 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.'

“All the other firms didn't have the confidence of having a Mike Milken who could sell this paper,” Joseph added. “So they had to look at spread sheets, figure out what had been done, and do one just like it. But we could just sit there with our minds wide open, smoke pot”—he laughs—“daydream, and say, ‘What do you want?' ”

Even with its inventiveness, Drexel was having trouble finding companies willing to pay what it took to raise money in 1981–82. And in its push to keep doing junk deals, Drexel did a couple that were notably outrageous. One was a $30 million offer in 1982 for Flight Transportation, a company which billed itself as offering jets for private charter to the Caribbean. There were, however, no jets, only a scam, and the FBI closed in shortly after the offering, while most of the money was still in escrow. Many of the bondholders sued, and they eventually achieved nearly full recovery in a settlement with Drexel.

“It was deliberate fraud on the part of Flight Transportation, but if we had been more careful we should have been able to spot it,” conceded Stanley Trottman, the investment banker whose deal it was. After the Flight Transportation debacle, Drexel instituted some controls on the freewheeling junk-bond enterprise. A private investigator, Jules Kroll, was hired to do background checks on Drexel clients. And the Underwriting Assistance Committee (UAC) was formed (in response to Flight Transportation and a couple of other bad deals that occurred just prior to it). A group of about eight to ten senior corporate-finance people and executives, the UAC was to review and authorize every deal the firm underwrote.

Trottman, who described the aftermath of Flight Transportation as “the worst period of my life,” suffered financially as well as emotionally. For by this time Fred Joseph had added 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.”

There was nothing Trottman could do to fix Flight Transportation. He received $50,000 as his bonus for 1982, while others in corporate finance received bonuses as high as $250,000-$300,000.

At least in Flight Transportation, Drexel was able to plead ignorance in the face of outright fraud. But in Drexel's deal for American Communications Industries (ACI), the situation was different. There, the risks were apparent.

In February 1981, Drexel issued $20 million of bonds for ACI, a movie production and distribution company which had been formed in 1978. The prospectus admitted that the company might not have sufficient earnings to cover the interest on the debentures. This was a foreshadowing of the statements that would later become boilerplate in Drexel's junk-bond prospectuses in its megadeals—but in those deals, like the $1.9 billion issue done in 1984 for Metromedia Broadcasting Corporation, for example, there would be assets that could and would be sold. Here there were none.

There was considerable compensation to the investors for their risk. The investors got bonds with a 12
³
/
₄
percent coupon (the coupon indicates how much interest is to be paid, usually semiannually) which were issued at a 70 percent discount. Warrants, included as sweeteners, were issued with the debentures in a unit.

These “unit” deals, which Milken had started issuing in 1980, had a special advantage for him. Typically, bond buyers and equity buyers are different groups, and many of Drexel's bond buyers therefore would not be interested in a company's warrants (exercisable into equity). Indeed, some high-yield mutual funds—which by the early eighties were still a giant part of this market—were not allowed to own equity. And these warrants were detachable from the
bonds. So Milken would strip off many of the warrants, sell the bonds separately and—according to sources both inside and outside of Drexel—sell them to favored clients at very favorable prices.

How risky a deal ACI was viewed as at Drexel may be deduced by noting not only what the investors got but also what Drexel got. Drexel claimed its lion's share of the 3 percent underwriting discount, which was $600,000. It also received stock in ACI, which the company had the right to repurchase up to a certain date at a maximum price of $700,000. Furthermore, ACI entered into a “consulting agreement” with Drexel, for which the firm would be paid $4,000 a month until April 1983 (for a sum total of $100,000). Such side deals were generally not a part of underwriting agreements at any major investment-banking firm.

The ACI offering took place in February 1981, and the first interest payment came due the following August. ACI became the first company in junk-bond history to default without making even one interest payment. One buyer said, “They didn't do what they said in the prospectus they were going to do. They were supposed to make only low-budget films. They got the money, and five months later it was all gone—along with everything else.”