The Predators’ Ball (11 page)

By late 1981, other companies for which Drexel had raised money began to falter and have trouble meeting their interest payments. This was not unique to Drexel clients. Corporate profits nationwide plummeted in 1981–82, and bankruptcies reached record post-Depression levels. But Drexel had carved out its niche with companies that were by definition high-risk, that few others would finance. One such marginal client in the midseventies had had to pay Drexel its fee in merchandise—thirty-three pinball machines—in lieu of cash.

“There were a bunch of these companies in trouble. We started a Special Planning Committee, which was the workout committee, except that Freddy [Joseph] didn't want to call it Workout,” Weinroth recalled. “We met on Friday afternoons. We'd walk out late on Fridays, and I'd say, ‘Freddy, I want to kill myself,' and he'd say, ‘Can I go first?' We'd never dealt with issues going bad before.”

Joseph remembered a meeting of the corporate-finance group at the Manhattan apartment of David Kay, who was one of Joseph's “Shearson Mafia” hires and was the head of the fledgling mergers-and-acquisitions group. Milken, in from L.A., came to the meeting.

“Mike was upset that all the deals hadn't turned out the way
we'd expected,” Joseph said. “We educated him that having access to a company's numbers doesn't make you a prophet. He allowed that, but said it was no reason for having him sell his clients paper that turned bad. So fix it.”

What evolved from this dialogue was Drexel's creation and virtual monopoly of a new business: the unregistered exchange offer. In a registered exchange offer, a company goes through the months-long process of registering a security with the SEC before offering it to bondholders in place of a formerly issued security. These had been done for many years. Riklis' exchange offers, for example, in which he extended the date of maturity again and again in each issue of his “Chinese paper,” were registered.

But whereas Riklis' exchange offers were motivated by his desire to postpone into the far-distant future the day when he would have to repay the principal, these Drexel-created exchange offers were designed to loosen the noose of interest-payment obligations on strangling companies. Milken's theory was that many companies don't go broke on the operating-profit line; rather, it is often financial charges that kill them. If there were a way of reducing or removing those charges, these companies might survive and ultimately return to health.

Drexel investment banker Paul Levy, who would come to specialize in this area, stated that its key is the concept of the “flexible balance sheet,” or adapting to a company's changing needs. If a company is being choked by its interest-payment obligations, why not make those payments in common stock? Or why not just exchange the old debt paper for common stock, and eliminate the charges entirely? In this new-age finance, nothing is written in stone. “People used to issue bonds, and after twenty years they would repay them,” Levy said. “That's hogwash!”

The bondholders would tend to accept these offers, no matter how displeasing, because they would find themselves between the proverbial rock and a hard place. As Levy explained, these exchange offers are essentially an arbitrage. If a buyer purchased at par a bond which then came to trade at sixty cents on the dollar, he would probably be willing to exchange it for a piece of paper trading at sixty-five cents—especially if he thought his alternative was to be stuck holding the bonds of a bankrupt company.

For these remedies to spell salvation for companies in such dire straits, however, they would have to be completed quickly; there
was no time for the months-long process of registering with the SEC. Drexel investment banker James Schneider, in the firm's San Francisco office, had had workouts on his mind through most of 1981, since ACI was his deal and he had had the responsibility for trying to salvage it. In early 1982, Schneider, who had obtained a law degree before turning to investment banking, claims he realized that the way to achieve these exchange offers with the requisite speed was through the window of Section 3(a)9 of the Securities Act of 1933. That provision allows companies to offer new paper in exchange for old, without having to go through registration. It stipulates, however, that investment bankers are prohibited from accepting fees for selling or promoting unregistered securities, and they may not solicit for the exchange. All the investment banker is allowed to do, then, is advise the company on what kind of exchange is most valuable to the company and most likely to find favor with the bondholders; after that, the solicitation is supposed to be left to the company.

Over the next four years, most other investment-banking firms would shy away from these transactions on the advice of their lawyers. Their attorneys took the position that it would be hard to define what was “promoting” or “soliciting” in these highly complex exchange offers, in which bondholders typically need a lot of explaining and persuading, and that their clients, the investment bankers, would be thrusting themselves into what was at best a gray area. Other investment-banking firms differentiate between the carrot-and-stick exchange offers for troubled companies—in which the bondholder has to be persuaded it is better to accept a less attractive piece of paper than risk default—and exchange offers done often in a defensive buyback, where the offer is so patently attractive that no solicitation would be required.

Commenting on this problem, Drexel's corporate-finance partner Mary Lou Malanowski said, “The buyers can talk to us—we just can't solicit them. And since we're in the aftermarket so much, talking to buyers all the time, we know what they want, they can talk to us, we can tell the company.” Malanowski added that the 3(a)9 for the troubled company has another advantage from Drexel's point of view, which is that it carries no underwriting liability. Since the securities are unregistered, Drexel's name does not appear on the prospectus.

Drexel completed its first 3(a)9 in 1981. Over the course of the
next five years, it would do about 175 of these exchange offers, the majority for troubled companies, involving a total of $7 billion of junk debt. According to an article by Randall Smith in
The Wall Street Journal
in September 1986, while other investment-banking firms that aggressively entered the junk-bond market through the eighties tended to experience high rates of default on their underwritings—9, 10, even 17 percent—Drexel with its lion's share of the market would have a default rate of just under 2 percent.

Drexel's low default rate was certainly not wholly attributable to its use of the 3(a)9. It had been in this business longer than nearly all its competitors, and its knowledge—reflected in its credit analysis and fashioning of the proper covenants for a given issue—was unrivaled. Still, those 3(a)9s did play a role in keeping Drexel's record—and, indeed, the record of the whole junk market, since Drexel did not limit its 3(a)9s to issues that it had underwritten—more default-free than it would otherwise have been. According to the
Journal
article, $2,927,000—or 3.4 percent—of all the public new-issue junk debt underwritten by the top fifteen underwriters from 1980 to September 1986 (totaling $86,043,000) went into default. Drexel's 3(a)9s were not exclusively for new-issue junk debt, so the comparison is imprecise. Nonetheless, if one assumes most conservatively that without that $7 billion of 3(a)9s another $2–3 billion of new-issue debt would have gone into default, then the dollar amount of defaulted debt noted in the
Journal
would have roughly doubled.

It seems plausible that a higher default percentage, or a sudden slew of defaults of Drexel-underwritten issues, might have dulled the growing institutional appetite for junk in this country in the early eighties. But if there ever was the possibility of an externally generated braking to Milken's machine, the 3(a)9 removed it. And with the 1981–82 recession weathered and the problem deals at least temporarily fixed, Milken was ready to move to a new plateau.

I
N
1983
THE WORLD
of junk exploded in size. By the end of 1983, 40 percent of all original-issue debt outstanding had been issued within the year—$7,310.2 billion. Twenty-three offerings of $100 million or larger were issued, compared to only eight in 1982. Drexel did $4,690 billion of junk offerings—three times the amount it had done the previous year.

In one ten-day period in February 1983, Drexel underwrote seven new issues totaling $500 million. In April, Drexel did the largest junk-bond offering ever, raising $400 million for MGM/UA Entertainment Company. And then, in July, $1 billion for MCI Communications.

Drexel's leap to these megadeals was not as smooth and effortless as it may have appeared to outsiders. One former Drexel employee recalls that Milken and his team were extremely nervous about the MGM/UA deal, since it was about four times bigger than anything they had ever done. “One of Mike's guys called me, wanting me to take ten million,” said this former Drexel retail salesman. “Now, whenever they had a good deal they didn't want to give it to me, because Mike hates retail, he has no use for it, he doesn't want to have to take calls from somebody asking for a million dollars of bonds when he wants to be dealing with a hundred million. And here they were asking me to take it. They said, you know, be a team player. So I did.

“Then it got oversubscribed. I got a call: ‘We want it back.' I'd already placed it with my clients. I said, ‘Forget it.' Then Mike's hit man [another of Mike's salesmen] called me. ‘You rotten . . .' —every obscenity in the book. Finally we compromised—I would cut
back five million, they would cut back five million. Even after that [he] started to call again, shouting that they had to have the rest.

“Mike plays very tough,” he said. “He doesn't get in there and do it himself—I've never heard him raise his voice. But he has people who do.”

The MCI deal started out at $500 million. Milken's sales force, however, kept coming back to him with reports of bigger and bigger demand; Milken moved to $600 million, then $800 million, then finally $1 billion. After all, the MGM/UA deal had been oversubscribed. But then, as the deal grew, the Street cooled; some buyers began to say that $1 billion was too much debt for the company, and that there would be too much dilution of the equity (warrants were being issued with the bonds).

At most investment-banking firms, if they had filed to do a junk underwriting for $100 million but found they could sell only $50 million, they typically would cut the deal back to whatever they could sell. But Milken had for years now made it a point of honor that he would not cut back a deal. As he would testify with apparent pride in a deposition in mid-1986, “I would say also that in my entire career on Wall Street I have never backed out of a transaction once I've agreed to stand up to it, no matter how onerous it turned out to be.”

This policy presumably sprang not only from Milken's sense of probity, but from his knowing it was good for business. It was meant to—and generally did—incur a sense of deep indebtedness in the client. Marshall Cogen of General Felt Industries, for example, recalls that in the hard times of 1980 Drexel filed to raise $60 million for General Felt but found they could sell less than half of that; the firm took the rest. As Cogen said in an interview in 1986, “I have never seen that done by another investment banking firm—
never.
Today everyone wants to bank us—Goldman, Lazard. But no one else would have raised that money back in 1980. And without it I never could have developed the base I have.”

In the $1 billion MCI offering, according to this former employee, Milken was able to place only about $750 million. The firm took the other $250 million. But not for long.

A couple of months after the MCI offering, HITS was born. HITS is Drexel's own high-yield mutual fund, sold by Drexel's retail staff to the public. And in its portfolio was a healthy slug of MCI paper.

HITS was not a dumping ground for bad paper, but an outlet
for deals where Drexel had trouble selling the paper and so had to buy a lot of it. HITS became one more cog in the increasingly well-integrated, high-powered Milken machine.

As the number and the size of deals increased in 1983, so did Drexel grow and prosper. The firm employed about fifty-five hundred people that year, up from three thousand in 1979. Milken's group had grown from the twenty or so with whom he had arrived in Century City to 130. In 1978 Drexel had placed eleventh among corporate-bond underwriters; now it was sixth. And the firm that had earned $6 million in profits in 1979 earned an estimated $150 million in 1983.

In 1983 Milken and his brother Lowell, in partnership with several other investors, bought a four-story building at what is probably the most exclusive commercial address in Beverly Hills, at the intersection of Wilshire Boulevard and Rodeo Drive. They then leased the building to Drexel, and it became the new Milken headquarters.

It was also a statement, a graphic précis of things to come. Milken had chosen to live in relatively unpretentious Encino, but that was for his tiny sliver of private, family life. For his business, which consumed virtually all his waking hours, he was now setting a very different stage. Milken's new office was smack in the middle of one of the most ostentatious displays of wealth that exist in this country, in a town that spawns every excess that money can buy. Milken chose this as his made-for-the-movies mecca. Over the next several years the stretch limousines would begin lining up at 4:30
A.M
. on the cobblestone driveway just behind Wilshire, their passengers—not only raiders but corporate chieftains as well—come for an audience with the King.

By 1983, too, Milken's investment partnerships—the repositories of much of his and his people's wealth—were multiplying. Other privately held firms on the Street had investment partnerships that were firmwide, as well as some in which certain partners participated and others did not. But only at Drexel was there a system so Byzantine, and so custom-made for patronage, manipulation and control by a single individual.