I just finished a book on insider trading. It was very interesting and also very vague with regards to the whole mergers and acquistions business. In the mid 80’s a group called Drexel financed many huge coporate takeovers. They had access to billions of dollars mostly financed through junk bonds. What is a junk bond? It seemed like a miracle way to get money.
A junk bond is a bond that the lender considers to be at a high risk of non-repayment. The interest rates of these bonds are a lot higher than normal to compensate the lender for the risk.
You can watch the movie “Barbarians at the Gate”, which will explain some of this to you and also be entertaining at the same time.
“Junk” bonds have very poor ratings, usually B or lower (depending upon which rating system is used). If your bond gets a bad rating, you have to pay more interest. Remember that when you buy a bond, you are buying somebody else’s debt. That person has an obligation to pay you back with interest. If the interest rate is high, the credit rating agencies think there is a chance that you won’t get anything back and the company will default on the bonds.
People who buy the junk bonds are essentially gambling that the hostile takeover will succeed. Sort of like backing a rebel duke in his effort to become king; if he wins, he promises you the tax revenue from a certain domain. A great deal, if he wins.
And should you wish to invest in them, they will often be termed “high yield” bonds, which sounds so much better. You will be able to find many “high yield” bond funds out there:
Those are funds which invest primarily in “junk” bonds. Note that “junk” status does not always indicate bonds issued by little known or fly-by-night companies. GM and Ford have been demoted to junk status in the last couple of years.
Right now, the spread between junk yields and safer investments is very low. There are some indications that it will widen in 2007.
Thanks for some good info.
Back to my OP. Drexel is clever enough to get companies to buy another company’s debt. They then use that money to finance corporate takeovers. Is that right? I’m confused as to how Drexel is the middleman that benefits from using junk bonds.
So are mortgages, which is the best analogy one can find to understand junk bonds. Just as a homeowner takes on debt based upon the asset value of the home they are buying to purchase the asset, debt allows one to purchase a company by issuing debt based upon the asset value of the company they wish to purchase.
To quote: “The term “junk” is reserved for all bonds with Standard & Poor’s ratings below BBB and/or Moody’s ratings below Baa. Investment grade bonds are generally legal for purchase by banks; junk bonds are not.” . Currently, as noted, GM and Ford is “junk”. So is most of the airline industry (except, maybe, SW), a good chunk of NASDAQ, the NYSE, and AMEX. That mom 'n pop grocery down the street? Junk. That gravel company down the road? Junk.
The number of companies that meet the above criteria for “Investment Grade” is small - fewer than 1% of all of America’s corporate entities qualify as “Investment Grade”. From the Great Depression to about 1975, the prudent investor (meaning everyone) invested only in those companies rated most solid by Moody’s or S&P, essentially distorting the bond market as to give access to it to those companies who had the least use for it.
Sometime in the early 1970s Michael Milken realized that the sub investment-grade market was just sitting there, vastly underutilized. Reading an 1940’s study about long-term investment value in high-yield bonds and applying it to the markets of the day (1972-76), Milken came to believe that a diverse collection of high-yield bonds in sub investment-grade companies would outperform the overall market, even if a few of them blew up in your face.
Companies that received “junk bond” financing from Milken to finance traditional growth included MCI, MGM, Viacom, Time-Warner, Toys-R-Us, Mattel, Hasbro, Hilton, Holiday Inn, Disney, 7-11 (and Circle-K!), Safeway, McCaw Communications, Barnes and Noble… and many more (list of companies taken from here). A lot of companies (even many with Investment Grade ratings) received junk-bond financing, usually in the form of subordinated debt (debt last on the list of being repaid if the company belly ups). However, there were only so many companies out there that could use Milken’s financing and he was running out of these “traditional” clients, those companies willing to take on stress-inducing levels of debt for a chance to grow.
Sometime about 1981-83, Milken had a brainstorm - Why can’t we just use the asset value of the company to float the junk bonds needed to buy undervalued companies? Remember, that at that time there were a large number of companies that, because of inflation and a bear market from 1968-1982, were worth far, far more than what their stock was selling for - if you bought the stock and then just sold the factories, dumped the excess inventory, etc, you could still make a profit.
The problem was management: established belief had it that management was all-powerful, and it was considered very risky (as well as unseemly) to just… take… a company away from its established management structure. That’s when Milken had his second brainstorm - F management. If their company is so undervalued that I can float debt that, if properly used (by buying stock), increases the stock price 70+% and results in a greater return for their shareholders, then that’s just a result of their mismanagement.*
So that’s what Milken did. He used his mastery of his original market to gather the pools of money needed to create the second market, the LBO market. He wasn’t the only one (Wasserstein and Perilla at First Boston had the idea as well), but he was by far the most connected financier in the country, working from his Rodeo Dr. (Hollywood, CA - Milken wasn’t based in NYC after 1977) offices from 4:00am to 7:00pm, every day.
Milken would create a pool of money from mutual funds, insurance companies, savings and loans, and pension funds, say $500,000,000. Using people like Steve Wynn, who used Milkens bonds to finance a gambling empire, and Henry Kravis, Oklahoma kid made good who eventually gained control of RJR Nabisco (to his regret), this pool of money was used to buy stock in the target, say Storer Communications or Gulf Oil. Eventually a formal announcement of a takeover had to be made, forms are filed with the SEC, lawyers and financiers are lined up, and the stock is now in play.
Usually, whatever happened, the stock went up for a while. The Board would have to hold a meeting where they consider the offer and any counter-offers that were made in the intervening time (usually management would put together a package, perhaps another buyout firm like Forstmann Little would get in the act), ending by accepting one or rejecting all (a rare occurrence).
Upon the offer being accepted, regulatory approval given, etc, the company would then issue enough debt to cover the expense of the buyout, including the cost of the shares, the banking and consulting fees, etc. The company, with new owners and a buttload of high-interest debt that must be paid by free cash-flow, would then look for means to enact cost-savings measures, up to and including selling divisions of the company in order to pay down the debt.
My wife and I did something like that: our first house was a duplex. We bought it with a 15 year mortgage on the property, lived in one half, and used the cash flow from renting out the other half to help pay the mortgage. In principle, this is the same as a LBO: using the cash-flow generating value of my home to pay down the debt needed to purchase the home.
Actually, that should be “debt allows one to purchase a company by issuing debt based upon the projected future cash flows of the company they wish to purchase.”
Not “assets” but “cash flow” as the most important thing to all bondholders is the companies ability to service its debt.
Thanks John T.
I’m not at all a business guy so you answered a lot of my questions.
Let’s see if I got this.
A company wants to buy another but they have no money except for the value of their own business. They float high risk bonds (which people buy?) to get the cash to buy the shares of another company. In essence they are saying to the bond purchaser “We are so confident of our ability to make money from this takeover that we will pay back the money we borrow from you at a high return”.
Where does Milkin come in? Is he the intermediary that has the contacts to get companies to buy the bonds and therefore raise the cash?
It’s not really a matter of being “clever”. In accounting, Assets - Liabilities = Equity
or another way to read it is Assets (cash) = Equity + Liabilities (debt ie bonds) = Equity (stocks)
So IOW, to raise cash (capital, which is an asset) a company can do two things:
- sell equity or ownership in the business in the form of stocks
- take out loans in the form of bonds
So unlike a stock where you buy a piece of the company, a bond is essentially a loan the company has taken with you. You purchase the bond and they agree to pay you the principle plus interest after a set period of time.
The advantage of a bond (junk or otherwise) is that you are more or less guaranteed a return. The disadvantage is that you generally don’t see as high a return that you would with stocks.
Bonds are generally “underwritten” by an investment bank or other financial institution who then resells them to individual investors. Generally the bank looses out if the company who issued the bonds becomes insolvent. Drexel Burnham Lambert is an investment bank.
In an M&A deal, the aquiring firm would issue high yield but risky “junk bonds” in order to pay for the aquisition. The idea was to use the cash flow from the acquired company to pay off the bonds. The risk is if interest rates suddenly rise or the merger doesnt go as well as expected, the acquiring company can find itself in some serious debt.