The Predators’ Ball (6 page)

Culture clash was the least of Drexel Burnham's problems. In 1975 the firm did very little investment banking; nearly all of Drexel's venerable old Fortune 500 clients had fled. Only Philadelphia Electric and a handful of smaller companies remained.

The firm's self-image, as it would later be recalled by one Drexel executive who arrived at the firm in the mid-1970s, was terrible. “Physically, Drexel Burnham was a pigsty. It was cheapskate in all its dealings—I once had a t and e form [an expense-account form] returned to me because I had taken a taxi where I might have taken a subway. And there were spotty compensation deals throughout the firm. It had a case of Monty Hall–itis.” Moreover, Drexel Burnham was peopled largely by “leftovers, people who hadn't worked out elsewhere, whose will had been broken.”

If Joseph was daunted, he did not show it. After six months at Drexel he told Kaplan that given fifteen years he could create something that might be as important as Goldman, Sachs, which was arguably the premier investment-banking firm on Wall Street and had been molded by one man, Gustave Levy.

Joseph's strategy was to develop an “edge.” And the first edge to work on, he decided, was service to medium-sized, emerging growth companies. There was nothing so original about this; many
firms had such a goal. Joseph, however, believed they gave it only lip service. At most firms, when a young partner brought in a deal for a small company, the firm wouldn't support the research and wouldn't make a market in the stock; while if another young partner obtained for the firm a co-management in an underwriting for IBM, he would be promoted. Drexel, Joseph determined, would say that it wanted to build medium-sized companies, and would mean it.

Joseph's strategy made particular sense because by the midseventies most of these companies had lost their investment bankers. They had been served by the submajors, but in the early seventies the ranks of those firms were decimated. In 1971 there were twenty-three submajors, among them Burnham and Company; by 1978, there were two. A handful had moved up into the majors, and the rest had disappeared.

Joseph fired six of the eighteen professionals in the corporate-finance department and began assembling his team. Although his nominal co-head of corporate finance, John Friday, a patrician, low-keyed holdover from Drexel Firestone, would remain at the firm until 1982—as a vocal, if solitary, critic of the junk-bond business—from the moment Joseph arrived Friday was history. Joseph made a decision not even to try to recruit bankers from Goldman or Lehman, but to take them from submajors like Thomson McKinnon or Dominick and Dominick—on the theory that morale would be better among people who were making a step up (to a major, albeit a ragged and schizophrenic one) than a step down. By mid-1976 he had assembled a group of twenty-eight in his corporate-finance department. Many had worked with him at Shearson (they became known as the “Shearson Mafia”) or had bounced around the submajor circuit.

Joseph wanted to make the compensation system as entrepreneurial as possible. Previously, the firm had allocated some portion of corporate-finance profits to the department as a bonus pool, and Friday had divided it up. Those early pools were not more than $50,000.

Joseph instituted a formula for corporate finance's bonus pool that made it more substantial—and would make it exponentially more so in years to come. What went into the bonus pool was a fixed percentage of the operating profits of the department, with extra credit given for certain kinds of deals. As the firm became
more successful, salaries remained moderate, and the real money was in the bonus pool. Joseph doled out from this pool according to explicit criteria he developed, rewarding the kinds of traits he prized for the firm's culture, penalizing those he wanted to extirpate.

Joseph's game plan was well suited to the times. And his ambition for the motley Drexel Burnham was enormous. But that game plan, fueled by his own fervor, would in all likelihood have produced one more small dot on the pointillist landscape of investment banking in the seventies and eighties, were it not for his alliance with Milken.

Several months after Joseph arrived at Drexel, he heard there was a “bright guy down on the trading floor doing deep-discount bonds.” “I went down and met him and it took me a while to figure out how good he was,” Joseph said. “It was clear he was very smart, but it was hard to interpret his fast trader talk, and he didn't know anything about banking and I didn't know anything about high-yield bonds, and it took us a while. We both kept looking at each other, thinking, Gee, I could probably do something with that guy.”

The first business on which Milken and the investment bankers coordinated was the REITs. Milken was trading the REIT bonds, and he began sending REIT managements over to the corporate-finance department. In 1976 there were 130 REITs. By 1984, Drexel would have done fee-paid transactions for about 95 of them.

The REITs, however, were only a warm-up. It was in the early spring of 1977 that Milken and Joseph decided to collaborate on an undertaking that would provide an “edge” commensurate with Joseph's ambition and would launch the firm on its trajectory. Lehman Brothers Kuhn Loeb, then one of the most prestigious investment-banking firms on Wall Street, had just underwritten several novel issues of low-grade, high-yielding bonds—$75 million for LTV Corporation, $75 million for Zapata Corporation, $60 million for Fuqua Industries and $53 million for Pan American World Airways. Until now, high-yielding bonds were the Chinese paper from the conglomerate-building exchange issues of the late sixties and from various and sundry fallen angels, high-grades which had been downgraded, including the REIT bonds. But these Lehman-underwritten issues were bonds which started out in life as junk.

Milken, who bought some of these bonds, pointed out to Joseph that he had the buyers for such low-rated paper—the clients he had
done business with since 1970. For by 1977, prior to the public issuance of non-investment-grade debt—as Milken would later note with some pride—there was already a thriving, vital high-yield market. “The value of this thesis was tested in 1970, and even more in 1974,” said Milken, adding that the bonds of many companies, including Loews, Rider, Tandy, Westinghouse, and Woolworth's, had plummeted in price in 1974; but within the next two or three years those prices rose dramatically.

“By 1977, what was important was we'd just gone through a difficult economic period, and people who had invested had had a very, very successful experience,” Milken continued. “Those investors who had confidence in '74 achieved rates of return in excess of forty percent. And it was their enthusiasm that then fueled this market in 1977.”

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.

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.

For Milken's investors, there was not only the appeal of the high interest rate, to compensate for the additional risk, but some upside: these companies' ratings might be upgraded. Furthermore, Milken guaranteed the investors liquidity. He told them that he would be there to make a bid on the bonds—it might not be a bid for what they had paid for the bonds, but it would be a bid. In essence, Milken was replacing more covenants (which an insurance company would have exacted in a private placement) with liquidity; so if an investor didn't like what a company was doing—as his mountaintop view was obscured—he could always sell his bonds.

And for Drexel, these bonds offered a walloping commission of 3–4 percent of the principal amount, as contrasted with the standard rate of seven eighths of one percent charged for underwriting high-grade bonds. The firm was embarked on what Joseph would later describe as its “high-value-added” course: as the years went on, Drexel would charge ever more astonishing fees for doing what no one else could do.

Milken had his stable of clients, but if this market was to thrive it would need a much broader base. Milken and Joseph quickly determined, however, that they would not distribute the bonds through Drexel's retail system. Milken followed the old Hickman credo on diversification. The retail customers with their small holdings would not have diversified portfolios, and without diversification Milken was convinced he would ultimately kill his clients.

The way to reach those retail buyers, Milken and Joseph decided, was to invent high-yield-bond funds, where the portfolio
would
be diversified. First Investors Fund for Income (FIFI) had been operating essentially as a high-yield-bond fund since Milken began tutoring David Solomon, in the midseventies. In 1976 FIFI had asked Drexel to raise capital for it. The project had foundered for close to a year, and now, in the spring of 1977—with the new junk bonds starting to be issued—Drexel's G. Christian Andersen and David Solomon set out on a cross-country road show to raise about $17 million.

“We took the story of high-yield bonds to the masses and to Wall Street and started to acquaint people with what the performance record [of FIFI] had been,” Andersen noted. “I saw there was a real market out there.”

FIFI became the first of the new “high-yield” funds, followed by Drexel-led underwritings for about a half-dozen more before the end of 1977. This was when the nomenclature, at least at Drexel, changed. As one Drexel investment banker remarked, “We knew we couldn't go to the public and ask them to invest in ‘junk.' ”

For the public, the allure was simple: riskless Treasury bonds were then offering a return of about 7.5 percent, while the funds' target was in the area of 10 percent. And for the fund managers whom Milken was assiduously courting, this new area sounded exciting. Mark Shenkman, who would later become a Milken devotee and was then equity-portfolio manager at Fidelity, had his first meeting with Milken at breakfast in 1977: “Mike said, ‘Why just be an equity manager when you could have a specialized niche, which takes into account equity research and trading inefficiencies, and offers good performance?' ” Shenkman relayed the Milken pitch to Jack O'Brien, in charge of product development for the Fidelity funds, and soon Fidelity started its first high-yield-bond fund.

While the Lehman issues had been sizable, Drexel started out small. In April 1977 its first deal was $30 million of subordinated debentures at 11.5 percent for a highly leveraged oil-and-gas-exploration and equipment-manufacturing company, Texas International. Though in later years Milken would forsake the notion of a syndicate and loathe the existence of even a single co-manager—why give bonds to other firms to place when he had more demand than he could fill, and why risk their finding out anything about his distribution?—in the beginning he did spread the risk. In the Texas International deal, Drexel Burnham took $7.15 million of the bonds to distribute, and the rest were allotted in tranches of under $1 million to fifty-nine other firms. The underwriting fee on the deal was 3 percent, or $900,000, of which Drexel collected the lion's share. In those days, that was a dramatically large fee.

By the end of 1977, Drexel did six more deals, all in modest amounts—ranging from $7.5 million to $27.5 million—and its total for the year was $124.5 million. While Drexel had done more deals than Lehman, Lehman ranked first for the year in amount, its total twice as large as Drexel's. Moreover, White, Weld and Company, E. F. Hutton and Company, and Blyth Eastman Dillon and Company all gave Drexel a run for its money, weighing in with fewer deals but in dollar amounts that came close to Drexel's.

That was the last time in junk-bond history that Milken's competition
would be able to touch him. In 1978 Drexel did fourteen issues for a total of $439.5 million, and its closest competitors for number of issues and amount did six issues and $157.9 million respectively. From then on, the numbers would tell a story of Drexel's dominance that grew more mammoth with each passing year, as the firm seized close to 70 percent of market share.

Lehman Brothers might have competed at the outset, but the business was too dicey for that high-class firm. Lewis Glucksman, the volatile trader who would for a brief, cataclysmic period several years later head Lehman, liked the junk business and believed the firm should make a strong commitment to it. But his partners on the investment-banking side disdained it. Lehman did only one more deal after that first batch and then turned down seventeen. They all went to Drexel.

Mark Shenkman, who left Fidelity in 1979 to set up a junk-trading operation at Lehman Brothers Kuhn Loeb, later recalled that “the big concern at Lehman was, ‘What will General Foods say [about its investment banking firm peddling such déclassé merchandise]?' All the establishment firms were slow coming into this business because they wanted to protect their franchise with the blue-chip companies. Drexel had no franchise to protect.”