The Golden Age of Junk

1.

Michael Milken was released from prison to a halfway house on January 4, 1993, after serving twenty-two months in jail for securities fraud and other crimes. His original ten-year sentence was reduced in 1992, because he cooperated, although only in a small way, with the government investigation. A month later, he was released from the halfway house to his home in Encino, California, where he remained under a “home confinement program” until his final release on March 2. He is required to perform community service for three years while on probation and has been working in a drug prevention program in Los Angeles public schools and has lectured at UCLA. He is now exploring the possibility of forming an educational cable-television network. At a dinner this April to raise funds for his foundation to cure prostate cancer, from which he suffers, Milken received a message from President Clinton who said how “impressed” he was by Milken’s “energy.”

The story of Milken’s early life is by now well known and differs little in the many accounts that have appeared. He was raised in a middleclass Jewish family in the San Fernando Valley. He was a good student, active in student government, a cheerleader who was elected prom king. While still in his teens, he resolved to become a millionaire by the time he was thirty, and he spent the mid-Sixties as a business major at Berkeley, aloof from the political and social currents of the time. An active member of his fraternity, he invested money for friends and fraternity brothers, absorbing all losses and keeping 50 percent of the profits. By 1970, two years after graduating from Berkeley, Milken had already decided what he wanted to do. In an op-ed piece, submitted to (and rejected by) The New York Times, he wrote: “Unlike other crusaders from Berkeley, I have chosen Wall Street as my battleground for improving society. It is here that the government’s institutions and industries are financed.”

He became fascinated with lowgrade or “junk” bonds while still an undergraduate, after reading W. Braddock Hickman’s 1958 study Corporate Bond Quality and Investor Experience. Junk bonds are securities that receive a low (below “investment-grade”) rating from Moody’s or Standard & Poor’s, the two major investment rating agencies.¹ They are not backed by company assets comparable to those of investment-grade bonds or by comparable cash flow. They also are traded in less liquid markets. If the company that issues them is successful, their yields are much higher than for investment-grade corporate bonds or government bonds, but the risk of default or non-payment is also considered to be high by the rating agencies. Still, Hickman and his National Bureau of Economic Research colleagues’ study of corporate bonds sold in the United States from 1900 to 1943 had found that a portfolio of these high-risk bonds usually outperformed the higher-rated, “safer” securities, “if the list is large and held over a long period.” They also cautioned that these returns were “subject to extreme aberrations over time.”

After Berkeley, Milken attended the Wharton School of Finance while working part time at Drexel Firestone, a declining Philadelphia investment banking firm descended from J.P. Morgan’s Drexel Morgan and Co. By the time the company merged with Burnham & Co., a New York brokerage firm, in 1971, Milken was working full time and commuting from outside Philadelphia to New York every day by bus. According to Connie Bruck, he spent his time on the bus reading bond prospectuses by the light of a miner’s helmet.²

Shortly after the merger, I.W. “Tubby” Burnham, the firm’s founder, established for Milken a semi-autonomous sales and trading unit with about $2 million in capital; Burnham agreed that Milken’s department would keep 35 percent of its profits from high-risk, high-yield bonds as well as up to 30 percent of profits earned in any other business that Milken brought to the firm. Milken also was in charge of allocating and distributing the bonuses paid to his department, which reputedly reached the seven-figure range by the mid-Seventies. This arrangement was still in effect in 1986 when Milken earned a record $550 million. “The only figure comparable to Milken who comes to mind,” Samuel L. Hayes III, a professor of investment banking at Harvard Business School, said to Business Week in July 1986, “is J.P. Morgan, Sr.”

2.

Milken’s rise was linked to several major economic trends of the Eighties: the growth of debt generally; the expansion of junk bonds in particular, and the rise of corporate mergers and acquisitions. During the decade, there was a huge growth of all kinds of debt. Credit, or “Money of the Mind” as James Grant calls it in his book of the same title, was critical to the economy’s recovery from recession in 1982 and its subsequent growth. Beginning in 1984, corporations began to borrow money and buy stock on a large scale (see Chart 1), often to make acquisitions or prevent an unwanted takeover by buying their own stock.

Chart 1

The share-holders who were bought out made large profits which further contributed to the US economy’s increasingly uneven distribution of income and wealth.

Growth in the junk-bond market accounted for much of the explosion of corporate debt as a whole. New issues of junk bonds increased in total value from less than $2 billion a year between 1980 and 1982 to about $13 billion a year in the next three years, and about $31 billion annually between 1986 and 1989. From 1983 to 1989 newly issued junk bonds accounted for 21 percent of all newly issued corporate debt compared to between 3 and 7 percent during the previous six years. About 17 percent of all corporate bonds outstanding between 1986 and 1990 were junk bonds. While many junk bonds were issued so that enterprising companies such as MCI or Turner Broadcasting could finance growth, by 1985 more than one third of all newly issued junk bonds were used to finance mergers and acquisitions. During the peak years of the decade, from 1986 to 1989, almost two thirds were used for these purposes (see Chart 2).

Chart 2

Drexel Burnham’s share of this highly profitable business averaged almost 50 percent between 1980 and 1989.

The early-to-mid-Eighties were a particularly inviting time for acquisitions. The economy was beginning to emerge from the most severe recession of the postwar period, yet valuations of public companies in the stock market were historically low relative to the value of their assets. In this setting, acquisitions mainly financed by debt—“highly leveraged”—were potentially very profitable, whether they were made with the cooperation of existing management (leveraged buyouts or LBOs) or against their will (hostile takeovers). In either case, borrowing large parts of the purchase price significantly increase the rate of return on investment.³ When investors reached a point where financing was hard to find, they typically resorted to junk bonds, whose market was largely controlled by Milken.

In the financial structure of “leveraged” corporations—i.e., corporations whose capital is largely borrowed—junk bonds generally fall somewhere between the most “senior” debt (which is often provided by banks and secured by the best of the company’s assets) and equity. Senior creditors have a higher claim on assets than the more junior bond holders, who in turn outrank equity shareholders. For much of the Eighties, corporations that were formed to make acquisitions or leveraged buyouts raised about half of their capital from bank loans, often secured by the assets of the companies being acquired, and 10 percent from equity investments, leaving a critical gap of about 40 percent which was raised by selling publicly traded junk bonds or borrowed from insurance companies and other lenders who specialized in junior debt.⁴

3.

Junk bonds were not very significant between World War II and the early 1980s, although they had been much used in the 1920s and 1930s, when they accounted for approximately 17 percent of newly issued corporate debt. A great many investment-grade bonds were downgraded during the Depression and by 1940 over 40 percent of all corporate bonds outstanding had junk-bond ratings. By the early 1970s, however, junk bonds accounted for less than 5 percent of all corporate bonds. While some were newly issued for companies such as Braniff Airways, most junk bonds were “fallen angels,” downgraded bonds like those of the Penn Central Corporation which was forced to declare bankruptcy in 1970 when it could not refinance its commercial paper. The large investment banks were not particularly interested in these securities and markets for them did not exist. It was in this “obscure backwater of Wall Street,” as James Stewart characterized it, that Michael Milken pursued his obsessions.

The keys to Milken’s success appear to have been his indefatigable research and considerable skills as a salesman. The research departments of the big Wall Street firms did not keep track of the companies that had issued high-yield securities. Milken used his growing and almost unique knowledge of such bonds both in his own trading and in cultivating clients who traded through Drexel. Milken’s network expanded quickly. He showed he could make profitable investments in undervalued securities such as the Penn Central bonds (the company’s assets would eventually benefit those who bought its depressed bonds at 20 cents or less on the dollar). And as he attracted loyal clients, he increased trading volume, which gave the market more “liquidity,” making it easier to trade.

Milken, as Stewart aptly put it, essentially “became the market for high-yield bonds.” As with any near monopoly, this was a market that Milken controlled and could manipulate. There were no published prices and Milken’s “spreads”—the difference between what he paid for securities and what he sold them for—were 3 or 4 percentage points, compared to the eighths and quarters of a point spreads typical for Treasury and investment-grade corporate bonds. Milken’s clients did not seem to care, however, as long as they also made money.

Milken’s early clients were not part of the Wall Street establishment. They included Saul Steinberg, Laurence Tisch, Carl Lindner, and Meshulam Riklis, an Israeli immigrant, husband of Pia Zadora, and the force behind a variety of acquisitions which included the liquor distributor Schenley Distributors and department stores like S. Klein and Best & Co. Some of them, like Riklis, had issued junk bonds themselves and clearly stood to benefit from greater interest on the part of investors in high-yield securities. Many, having recognized the tremendous potential of capital-rich insurance companies for providing them with funds to invest, acquired or ran insurance companies and made them the center of their operations. (This was also true of the legendary investor Warren Buffett, an outspoken opponent of junk bonds.) All had previously sought to circumvent the established ways of doing business and several had run-ins with the Securities and Exchange Commission (SEC).⁵

Milken completed Drexel’s first underwriting of a new issue of junk bonds in 1977. A $30 million offering for the oil and gas producer Texas International—now Phoenix Resources—earned the firm an underwriting fee of 3 percent, more than triple the typical fee for underwriting investment-grade bonds.⁶ Drexel’s business took another leap when the firm began financing leveraged buyouts in 1981. By this time, Milken had moved the high-yield bond operation to Los Angeles, where he consolidated its power and independence, and established a separate identity. He often put in sixteen-hour days that began at 4:30 AM, and everyone had to conform to his frantic pace.

According to Kornbluth, however, it was the Drexel corporate finance department that first came up with the new idea of using junk bonds to finance leveraged buyouts. Buyers would create their own “shell” companies expressly in order to sell bonds that would finance the purchase of the target firms. Milken was said to have feared at first that the “incremental risk” of these transactions would sour investors on junk bonds generally, but he can’t have protested too much, and the firm’s business flourished. In 1983, its revenues were almost $1 billion, and Milken’s own take was more than $100 million.

A second major boost to Milken’s fortunes was the decision, arrived at late in 1983 and unveiled with great fanfare at Drexel’s annual high-yield bond conference the following spring, to provide junk-bond financing for hostile takeovers—essentially LBOs carried out against the current owners’ will. This was a natural sequel to the decision to use junk bonds to finance LBOs approved by the people in control of the company and it followed a similar brainstorming session about which accounts differ. According to some sources cited by Kornbluth, Milken once again expressed reservations, in this case because he was concerned about the likely backlash from the management of companies that felt threatened and the political support they could muster. Others remember Milken as giving enthusiastic support to financing hostile takeovers. If Milken had misgivings, they were swept aside by the enormous profits and his overriding desire to dominate the market. As Drexel’s chairman Robert E. Linton put it, “Michael wants to win the game. Michael wants to have it all. Michael wants to do every piece of business and every deal and make every dollar.”⁷

In Money of the Mind, James Grant singles out two transactions in particular as marking the beginning of the frenzied increase of acquisition activity and of junk-bond issues that continued throughout the decade: the November 1984 sale of $1.3 billion of junk bonds by Metromedia Broadcasting to refinance the temporary bank loans that the company had used in June to go private in the biggest LBO to date; and the $6.4 billion acquisition of Beatrice Companies by the leveraged buyout firm Kohlberg, Kravis, Roberts & Co. (KKR) about a year later. Drexel financed both transactions and earned fees in excess of $100 million.⁸

It is hard to say just how influential these two transactions were for investors. But a number of highly profitable deals in the early Eighties unquestionably caught Wall Street’s attention. An earlier, but far smaller example of the powers of leverage in an economy emerging from recession was the purchase in January 1982 of Gibson Greeting Cards from RCA by former Treasury secretary William Simon and his partners. They borrowed $79 million of the $80 million purchase price. Less than two years later the company was taken public in an offering that valued the equity at almost $300 million.

The Gibson transaction also demonstrates that stagnant corporate bureaucracies had a large part in creating the opportunities exploited by raiders and LBO firms. Gibson and three other manufacturing companies had been acquired by the large CIT Financial Corporation in the conglomerate merger wave of the 1960s. RCA acquired CIT in January 1980. The CIT companies were not very large and seemed remote from RCA’s main business of consumer electronics and entertainment. They had become less profitable in the weakened economy of the Seventies and top management decided to “get them off the books” at what turned out to be the worst possible time.⁹

There were also a number of prominent raids on large oil companies in this period, including successive attacks on Phillips Petroleum by T. Boone Pickens and Carl Icahn. Icahn’s tender offer—a public announcement offering to buy out shareholders at higher than market prices—for Phillips was notable also because it was backed largely by Drexel’s assertion that it was “highly confident” it could raise the financing. This was a change from the conventional (and more costly) “commitment” to do so.¹⁰

The takeover of Storer Communications, acquired by KKR shortly before it took over Beatrice, shows some of Milken’s other strategies. Storer, like Metromedia, owned several television stations as well as the fourth largest cable system in the country. Drexel sold almost $2 billion of highly speculative junk bonds and preferred stock to enable the company formed by KKR to acquire Storer. Milken said that in order to get his clients to buy the securities he had to have an “equity sweetener” in the form of warrants, i.e., guarantees that investors will be able to buy stock at a fixed price in the newly formed company. Most of the warrants, however, ended up not in his clients’ portfolios but were acquired separately by McPherson Partners, a partnership created expressly to hold warrants, which was owned mostly by Milken, his brother, and their families. The partners at McPherson also included key Drexel employees, and various mutual-fund managers whose funds had participated in this and many other Milken offerings. The chance to participate in McPherson was an incentive for them to continue to be good customers and employees of Milken and Drexel. When KKR sold Storer’s television stations and cable properties a few years later the warrants yielded a profit of almost $200 million. Some of the Storer properties were bought by other Milken clients whom he also financed.

These manipulations of the market, in which valuable warrants and other “gratuities” were granted to important buyers of junk bonds, and securities and properties were traded within Milken’s network,¹¹ were critical to his continued control of about half of the larger, and riskier, junk-bond market that emerged in the second half of the decade. To the junk-bond issuers, it mattered little whether Milken, his favorite employees and fund managers, or the funds themselves got the warrants so long as the deals were consummated. But from the perspective of the ultimate owners of the bonds, the pension and mutual fund share-holders, it made a large difference. First, Milken’s practice of diverting warrants to his own companies deprived them of the total returns that were appropriate for the risks they were bearing; and second, they could not count on their fund managers and the others who were legally responsible for representing the interests of the investors to make an unbiased appraisal of risks and rewards. ¹² But neither complained: the issuers because they didn’t care and the buyers because they didn’t know.

4.

By the mid-1980s, the success of highly publicized buyouts made the case for junk bonds far more persuasively than did Drexel’s promotional pamphlet “The Case for High Yield Bonds,” or any of the academic studies showing that the default rates for high-yield securities were low.¹³ The extremely profitable deals precipitated a virtual frenzy in both the high-yield and stock markets. The notion of “private market value,” i.e., not the listed market value for shares in a company, but what a buyer would hypothetically pay for an entire company, increasingly influenced stock market valuations and impelled takeover groups to accumulate stock in potential targets. Their purchases were followed closely by risk arbitrageurs—professional investors who speculate on takeovers in the hope that the deals will be consummated—often aided by computer programs that picked out stocks with unusual trading volume. Ultimately, even retail customers were drawn into the action. LBO firms like KKR and Forstmann Little & Co. proliferated, supported by insurance companies, pension funds, “high net-worth individuals,” and others who wanted to share in the abnormally high returns.

Corporate managers responded to the growing threat of takeovers and buyouts both by fighting them and joining them. They attacked corporate raiders and their junk-bond financiers in the press, in Washington, and in state legislatures and regulatory agencies. They also arranged for leveraged buyouts of their own companies, thereby taking these companies out of play, preserving their positions, and, when possible, earning abnormal returns. The enormous power and profits earned by Milken and Drexel Burnham also stimulated many of the more established investment banks such as First Boston, Goldman Sachs, Merrill Lynch, and Salomon Brothers to compete aggressively in both the takeover and junk-bond markets. They suggested takeover targets and offered financing in an effort to capture some of Drexel’s market share.

Once they were more highly contested, however, deals also became more reckless. Nineteen eighty-six stands out as a clear turning point in the takeover and junk-bond markets. As chart 2 on page 29 shows, the total amount of junk bonds issued doubled in 1984 and in 1986, while the average size of each new issue and the use of the proceeds for takeovers sharply increased. The quality of newly issued junk bonds also deteriorated sharply as the volume surged after 1985—just as Hickman and his colleagues had discovered sixty years earlier. Many companies issuing junk bonds in the overheated markets between 1986 and 1989 could make the required interest payments only if their cash flow grew rapidly or they could sell assets at favorable prices. And these possibilities depended, in turn, on the companies being more efficient as well as on continued growth in the economy and continued strength in the junk bond and acquisition markets.¹⁴

It was just at this time, however that the prosecutions for insider trading and related violations of securities laws that would eventually undermine Milken began to emerge—beginning in May 1986, with the charges brought against Dennis Levine, a relatively obscure investment banker at Drexel Burnham. Within a year, Ivan Boesky, a risk arbitrageur, and Martin Siegel, an investment banker who had earned his reputation defending clients from unsolicited takeovers, had also pleaded guilty to trading inside information about forthcoming company takeovers. Boesky paid fines and penalties of $100 million and promised to cooperate with the accelerating investigation. Drexel and Milken were charged with insider trading, stock manipulations, fraud, and other violations of the securities laws in September 1988; by the end of the year Drexel had agreed to plead guilty to six felonies, including racketeering and securities fraud, settle charges with the SEC, and pay a $650 million fine. As part of the settlement, Milken was forced to resign from the firm.

Boesky was the largest and most widely known risk arbitrageur. This was in part owing to his close ties to Milken, who sold almost $1 billion of high-yield bonds for Boesky’s own arbitrage investment firms from 1983 to 1986. Risk arbitrageurs are highly dependent on information about mergers and acquisitions and routinely talk to investment bankers and lawyers who are involved in deals. They can also be very useful to the bankers and lawyers since they often control large blocks of stock in the target companies and can determine the outcome of a takeover struggle. A fine and poorly defined line divides appropriate from “inside” information—information not generally available that was obtained from people with some involvement with the firms. (This latter category has expanded over the last few years to include people, such as lawyers and investment bankers, who are not employed within the corporation but are entrusted with confidential information.) Boesky clearly overstepped the legal boundaries by paying both Siegel and Levine for privileged information about company takeover plans—perhaps because his investment results had not been matching his reputation and the pressure to meet the interest payments on his own junk bonds was high.

Boesky may also have obtained inside information from Milken or his associates. Milken was indicted for insider trading, for example, in tipping off Boesky that Occidental Petroleum, for which Drexel acted as an adviser, was about to merge with another company.¹⁵ But Milken did not admit this when he pleaded guilty, and paid a $600 million fine. Nevertheless, Milken’s relationship to Boesky was central to his downfall. Of the six comparatively technical felonies to which Milken pleaded guilty after much bargaining with the government, four involved Boesky. For example, Milken admitted secretly guaranteeing Boesky against losses in buying the stock of Fischbach Corporation, which another Milken client, Victor Posner, wanted to take over. Posner had been maneuvered into signing an agreement with Fischbach that prevented him from buying any more stock unless another potential bidder acquired at least 10 percent of Fischbach’s shares. Encouraged by Milken’s guarantees against losses, Boesky acquired 10 percent of the company’s stock, thus freeing Posner from the agreement and allowing Milken to finance Posner’s acquisition of control by issuing junk bonds. Boesky did not disclose the guarantees, as required by law, and Milken pleaded guilty to aiding and abetting him in filing false statements.¹⁶

5.

By the end of the 1980s, the economy began to weaken, further threatening the risky acquisitions and junk bond issues, which depended on improved profitability and asset sales. In the middle of 1989, the junk-bond market was shaken by a series of defaults, starting with Integrated Resources and Southmark Corporation, real-estate syndicators sponsored by Drexel, and including such companies as Resorts International, Seaman Furniture, Western Union, and Campeau Corporation (which had acquired both Allied and Federated Department Stores, owners of such established chains as Brooks Brothers and Bloomingdale’s).

The rate at which junk bonds were issued fell drastically in 1990—from approximately $30 billion a year during the previous four years to under $2 billion. Investment in buyouts, which had grown from less than $1 billion in 1980 to a peak of over $60 billion in 1988, declined to less than $4 billion in 1990. In 1989, junk-bond defaults exceeded $8 billion, more than the amount of junk bonds issued in any year before 1984, and more than double the amount that had defaulted in any year since at least 1970. The year 1990 was even worse. The deteriorating economy, combined with a scandal-wracked junk-bond market that had absorbed so many risky issues since 1985, pushed defaults to almost $20 billion. Instead of making money, investors in junk bonds took a large overall loss of 8.6 percent in 1990.¹⁷

July 1990 was later judged to be the beginning of the recession, and junk bonds, takeovers, and shortsighted trading were increasingly blamed for the slowdown in economic growth as well as for the S&L crisis and the longer-term declines in American competitiveness and growth in productivity.¹⁸ The surge in junk-bond defaults occurred despite improvements in the day-to-day operations at many of these companies. Southland Corporation (the owner of 7–Eleven stores), for example, was acquired in a leveraged buyout financed by Goldman Sachs in 1987. Its pretax earnings increased by over 11 percent over the next two years, but the company still defaulted in March of 1990. The improvements in financial performance were not sufficient to overcome the burdens posed by the riskier financial structures that resulted from changes in the trading world: higher acquisition prices, necessitating the use of more and more debt, particularly junk bonds; buyouts of companies in less stable industries; and bank debt that required accelerated repayment.

At the same time company managers, deal promoters, and investment bankers had all been charging heftier up-front fees to arrange the transactions and issue junk bonds. These fees, and the competition they induced, were a major factor in the overheating and burnout of the junk-bond market. Warren Buffett wrote to his share-holders in 1990:

As usual, the Street’s enthusiasm for an idea was proportional not to its merit, but rather to the revenue it would produce. Mountains of junk bonds were sold by those who didn’t care to those who didn’t think—and there was no shortage of either.¹⁹

Many of these fees were paid just for completing a transaction, regardless of its ultimate success. In addition to the fees of junk-bond underwriters, typically 3 to 4 percent of the size of the issues (almost $5 billion from 1986 through 1989), there were advisory fees for investment bankers, commitment fees for the lenders, and various legal and accounting fees. (Each participant generally needed his own experts and counsel.) Firms specializing in buyouts often earned three sets of fees, one for closing transactions, a second for monitoring the companies they acquired, and an annual fee of between 1 and 2 percent on the money under management. They also typically took 20 percent of profits on successful deals, without sharing the losses.

To have fees based on the size of transactions clearly encouraged the wrong tendency, a rush to transact more and bigger deals and to discount the importance of longer term profitability. Even profit-sharing arrangements did not deter rabid deal-making since the fees were often based on individual transactions and did not require profits to be balanced by losses before gains were split. Most of the detailed work on deals was done by junior employees whose compensation and bonuses were related to their “productivity” or success in completing transactions; and they did the research and organized the information which formed the basis for investment decisions.

6.

Overheated financial markets and speculative breakouts are nothing new. The takeover wave of the 1980s was the fourth to take place during this century, each of which occurred in the midst of a wildly bullish stock market. By 1989, almost 30 percent of 1980’s Fortune 500 companies had changed hands, and more than $1.25 trillion of assets had been bought and sold. (Investment banking fees alone were probably on the order of $20 billion.) These acquisitions, like those that took place at the turn of the century and in the late Twenties, but unlike the conglomerate mergers of the 1960s, tended to combine firms in the same lines of business.²⁰

The conglomerate merger wave of the Sixties led to combinations of diverse groups of companies such as Litton Industries, an electronics company that branched out into packaged foods, teaching aids, and ships, and International Telephone and Telegraph, which owned Hartford Insurance, Sheraton hotels, and Avis rental cars as well as Wonder Bread and Hostess Twinkies. Strict antitrust policy made acquisitions in the same line of business difficult, while centralized management, personified by ITT’s Harold Geneen and Litton’s “Tex” Thornton, was supposed to improve efficiency. As it turned out, bloated bureaucracies, cheap capital, and the diversity of operations and lack of operating experience among top managers contributed to the over-all failure of conglomerate mergers, and to the slowdown of productivity growth and loss of market share in world markets during the 1970s.

These developments also set the stage for the acquisitions and take-overs of the 1980s which shifted the trend from conglomerate corporations to more specialized ones. Stimulated by the buoyant junk-bond market, and by lax antitrust enforcement, the unsuccessful conglomerate companies began to sell of their less profitable divisions on a large scale. Almost two thirds of all conglomerate acquisitions made between 1970 and 1982 had been resold by 1989. In industries such as airlines, or oil and gas, large companies bought other firms in the same lines of business, sometimes after the firms had been threatened by corporate raiders. Similarly, many of the companies acquired in hostile acquisitions and LBOs were ultimately sold to buyers already operating in those businesses.

Conglomerates were often inviting targets for raiders. Stock market valuations of their shares could be flagrantly low, particularly when the valuations were owing to unprofitable branches of the company that could be shut down at low cost by an acquirer (but not a passive shareholder) even if they couldn’t be sold. To a large extent, corporate raiders and LBO firms were brokers rather than permanent owners, helping to redeploy assets to more profitable uses. Almost one third of the assets acquired in a sample of sixty-two hostile takeovers between 1984 and 1986 were sold within three years, about 70 percent to buyers in the same business. A good example is Revlon, which was acquired by Ronald Perelman in a $2.5 billion hostile takeover in 1985. Revlon had acquired a large range of subsidiaries outside its cosmetics base, including several healthcare companies. Perelman soon brought in $2 billion by selling off most of the other businesses, thus enabling him to spend more money on strengthening the core cosmetics business that had been neglected.

The takeovers of the Eighties improved efficiency in a number of ways. First, many business divisions performed better once they had joined more specialized companies. Second, the acquired firms, which were often less profitable than the buyer-companies, benefited from being affiliated with more efficient operations. Finally, in some cases, hostile takeovers managed to replace ineffective and overpaid corporate management with more efficient managers. Without large shareholders, or the possibility of a takeover, the former, non-owner managers had been relatively free to sacrifice profit and efficiency to personal security and success. Leveraged buyout firms and corporate raiders sought to overcome these tendencies by actively managing their acquisitions, holding management more accountable, and introducing employee incentives based on contribution to profits.

Gordon Cain, a particularly successful example, acquired six chemical plants in LBOs in 1987 and combined them into one company—Cain Chemical—which doubled in value in just ten months when the company was sold to Occidental Petroleum; the $24 million equity investment increased about forty-four times to $1.25 billion. As in all his deals, Cain insisted that all “key managers” purchase stock to promote “higher morale, commitment, and involvement.” In addition, almost 15 percent of the company’s stock was given to the workers through an employee stock ownership plan, and 10 percent of the firm’s excess profit was distributed to employees each quarter. Most employees netted at least $100,000 from the sale. Cain made $100 million but claims that he probably wouldn’t have sold the company at that time if not for the immediate large gains for the workers and management.

There are signs that American business has recently concentrated more intensely on improving productivity and profitability, whether because of the continuing pressure of international competition, the recession, or the influence of the takeover wave of the 1980s. The belated responses of the directors of General Motors and IBM to their firms’ deep structural problems are highly visible examples. More generally, productivity has been rising at approximately 2.5 percent per year since the recovery began in April 1991, about the same as during the prosperous postwar years, 1948 to 1973, and more than twice as rapidly as the average from 1970 to 1990. But it is not clear whether the increase in productivity growth is the start of a new longer-term trend or merely a temporary rebound from the particularly depressed rates between 1987 and 1991.²¹

On the other hand, productivity gains have been accompanied by large-scale layoffs of white-collar workers as well as blue-collar workers during the 1990s, and growth in employment has become sluggish. (For the first time, unemployed white-collar workers outnumbered unemployed blue-collar workers in early 1993.) The Eighties takeovers also had a direct effect on employment, although it was not large compared to the layoffs at such corporate giants as GM and IBM: a survey of sixty-two hostile takeovers in the mid-Eighties found that roughly 2.5 percent of the average company’s work force was subsequently laid off.

Bankruptcies and corporate distress caused by unproductive uses of junk bonds wasted resources and disrupted lives and communities. Foolish investment decisions were encouraged, in part, by the gifts of warrants and other favorable investment opportunities that Milken handed out to important clients and managers of large pools of capital, and by the large fees and bonuses based on the volume of transactions that were paid to deal makers and money managers. The pattern was self-perpetuating: Milken and Drexel’s enormous profits elicited a strong competitive challenge from other investment banks which increased the pressure on Milken to hold on to his share of the market.

The evidence about junk bonds, takeovers, and Michael Milken is thus mixed. Estimating their positive and negative effects is extremely difficult, and I know of no serious attempts to do so. I suspect that the good effects outweighed the bad primarily because they contributed to a generally more competitive business environment. What is clear is that neither of the extreme versions of Milken’s activities rings true. The claims of Milken and his supporters that he was a naive genius, a “social scientist” who just couldn’t say no to those who wanted to push leveraged deals beyond the bounds of reason, seem particularly hollow. In one interview Milken maintained that he had come to oppose the expansion of junk-bond credit:

After 1986 I felt like a skilled surgeon who’s been locked out of the operating room and watches through the glass in horror as some first-year medical students go to work on a patient….

Yet Milken maintained a commanding share of an extremely profitable market for at least a decade, a market position which had to be actively created and defended, and he showed no inclination to set stricter standards for the junk bonds he floated.

It is similarly hard to take seriously the notion, expressed most explicitly by Benjamin Stein, that Milken’s junk bond operations were a vast conspiracy, a giant Ponzi scheme designed to bilk the public. The changes that junk bonds made possible—especially the financing they provided for such innovations as telecommunications, cable television, and computers—were real and would almost certainly have been financed by others, albeit at a different pace. In my view, one of the great tragedies of the Eighties’ financial world is that recklessness and fraud intensified just as Milken and others started to seriously explore acquisitions by employees. If they had found ways to provide financing for takeovers by workers who had their own close knowledge of the business they might have left an altogether more interesting and positive legacy.²²