The Predators’ Ball (41 page)

In their 1985 annual report, the President's Council of Economic Advisers had weighed in with its conclusions, surprising only in their ambitiousness. They purported to settle once and for all the decades-long debate over whether takeovers are beneficial or harmful. This august council concluded that mergers and acquisitions “improve efficiency, transfer scarce resources to higher valued uses, and stimulate effective corporate management.” The conclusion was remarkably definitive but, apparently, more polemical than proven. In some of the more interesting testimony that emerged from the congressional hearings on takeovers, F. M. Scherer, a Swarthmore College economics professor, had rebutted the Council's findings. In his testimony in March 1985 he pointed out that the report's conclusion that takeovers improve efficiency relied on stock market event studies, which are short-run in orientation (examining stock prices during periods ten to thirty days before and after the announcement or consummation of the merger). If one looks at a period of ten years or so, Professor Scherer testified, the results are very different.

Scherer has developed the premier data base in this country for looking at the financial consequences of merger. This data base draws upon twenty-seven years of merger history and seven years of sell-off history for nearly four thousand individual businesses.

These are some of Scherer's findings, from his case studies and statistical research:

• Contrary to the Council's view that merger-makers sought companies where management had failed, most in fact targeted well-managed entities (such as National Can). What they were generally attracted by was not sick companies or slipshod management but undervalued assets.

• Takeovers by firms with no managerial expertise in the acquired company's line of business tended to impair, not improve, efficiency.

• Takeovers frequently led to short-run profit-maximizing strategies, such as the “cash cow” strategy under which “a business is
starved of R&D, equipment modernization, and advertising funds, and/or prices are set at high levels inviting competitor inroads, leaving in the end a depleted, non-competitive shell.”

• On average, acquisitions were less profitable for the acquiring firms than the maintenance of existing businesses and the internal development of new business lines.

• Many takeovers led to selloffs, which did improve the efficiency of the simpler, self-standing entity.

• While Scherer had relatively few hostile takeovers in his sampling, in those he did study he found that the takeover aggravated performance deficiencies that existed earlier.

In response to questions from panel members, Scherer also made an interesting point about the high-leverage, or debt-intensive, capital structures of many U.S. companies, which are coming to resemble Japanese companies' financial structures. Indeed, in the gospel according to Milken which is spread by so many of his acolytes, it is often noted that Japanese companies have for years carried much higher debt-to-equity ratios than American companies. True enough, Scherer commented, but the Japanese are able to carry such high levels of debt because when they get into financial difficulties the government bails them out.

Scherer's testimony was followed by that of Warren Law, a professor at Harvard Business School. Law too had come to rebut the “glittering generalities” of the Council's report. The Council's reliance upon short-run stock market behavior as evidence that takeovers are beneficial, he said, could be accepted only if the stock market were a good judge of intrinsic values. (As Milken and his entire coterie of raiders—who had made billions by identifying assets undervalued by the market—could have told this group, it is not.)

Law added that he did not believe that it could be strictly proven that takeovers deter or promote growth and productivity. Inasmuch as “we cannot run history twice with and without them, we can only speculate.” With this caveat, however, his speculation is that takeovers decrease productivity. He bases this view on a number of factors. Through takeovers, bigger firms are created, and he believes that large firms “make fewer but bigger errors, tend to continue wrong policies too long, and have the resources to delay until crisis is unmistakable.”

Furthermore, he pointed out that in the late 1970s approximately
half of all corporate acquisitions were also corporate divestitures, many of them businesses which were acquired during the last merger heyday of the 1960s. That wave, he said, was accompanied by “an increasing tendency of executive suites to be dominated by people with financial and legal skills, executives who believed a manager with no special expertise in any particular industry could nevertheless step into an unfamiliar company and run it successfully through strict application of financial controls. The present dismantling of many conglomerates is the result of this folly. There is no reason to believe the result will differ this time.”

The takeover debate would be laid to rest neither by the 1985 annual report of the President's Council of Economic Advisers nor by Professor Scherer's research. While Scherer's conclusions appeared to be much more soundly based, one reason the debate has been so long-lived is that there is some truth on both sides. Some takeovers do result in more efficient and profitable companies, even when the new manager-owner has no expertise in the industry and has been, as Frank Considine put it, a
financial
operator, but not an operator—as in the case, thus far, of Carl Icahn and TWA. Some, on the other hand, do result in companies so debt-laden that their R&D budgets are starved and they become noncompetitive—as could conceivably become the case with Uniroyal Chemical, which was the profitable, healthy core of the old Uniroyal and in its brief tenure under Nelson Peltz's aegis earned barely enough to cover the interest charges on its mountain of $1.06 billion debt. The questions that remain, of course—which of these scenarios occurs more often, and whether there is indeed a preponderance sufficiently quantifiable and large that one can conclude that most takeovers are beneficial or harmful—will not be able to be meaningfully addressed for the most recent wave of buyouts and takeovers for years.

Despite the reservations that both Scherer and Law voiced about takeovers during their testimony before Congress, neither professor was wholeheartedly endorsing anti-takeover legislation, since both were wary of efforts of the federal government to tinker with the tender-offer process. Law, however, did favor legislation to abolish greenmail. And Scherer was in favor of changing the tax law that favors the issuing of debt over equity by making interest payments (on debt) deductible but dividends (on stock) not.

No law to abolish greenmail was passed. While sweeping changes were made in the Tax Reform Act of 1986, that debt-favoring
provision was not one of them. And the only regulatory measure affecting takeovers that
was
put into effect gave credence to the view that the government might as well stay out of the takeover arena, since its rules are no sooner passed than they become obsolete.

In December 1985, the Federal Reserve Board had proposed a measure that would apply its margin regulations to junk bonds issued by shell companies to finance acquisitions. Margin rules restrict the use of borrowed money in buying stock, generally allowing no more than 50 percent to be borrowed.

As the Fed's proposal was interpreted at the time, this would mean that buyers intent on financing a takeover would be allowed to borrow only 50 percent of the purchase price against stockholder equity of the target, rather than what had become the vogue in 1985—80 percent or more. In other words, they could no longer buy a company by using the company's own equity as collateral for loans. It was just such an enforcement of the margin rules which first Unocal (in its petition to the Fed) and later Revlon (in court) had argued for when they were under attack.

The Fed's proposed ruling elicited an extraordinarily vehement response from the Reagan Administration. The Justice Department was joined in its opposition by the Treasury Department, the Office of Management and Budget and others. Even within the Fed there was dissension. Chairman Paul Volcker, who had been an outspoken critic of high leverage and debt-financed acquisitions, was the measure's driving force, but the two Reagan appointees to the Fed's board of governors, vice-chairman Preston Martin and Martha Seger, both dissented from the board's recommendation.

Wall Street was divided on the measure. Salomon Brothers, for example, was in favor of it, while Drexel of course mounted a blitzkrieg of lobbying against it. Even Milken, who typically did not make the politicking treks to Washington that Fred Joseph, Chris Andersen and others in the firm did, tried to lend a hand. “Milken wanted to come and see the chairman and talk about capital markets,” recalled Michael Bradfield, the Fed's general counsel. “We wouldn't let him come.

“Everybody considered that bad form, trying to initiate exparte contact, trying to get in the back door. It was supposed to be all public comment,” Bradfield continued. In February, after the proposal had been approved, Joseph paid a visit to Volcker.

The rule was finally adopted, but considerably watered down. The original proposal might have let the government review proposed takeovers based on the respective sizes of the acquirer and the target. But the rule as passed applied only to hostile takeovers by shell companies—and shell companies narrowly defined as having
no
assets or operations.

After all the furor, the rule was irrelevant. One way to get around it was to use as acquiring vehicle a company that had some business, however slight. Another way was to use preferred stock instead of bonds. Preferred stock generally acts like debt (it pays an interest-like dividend, and it gives the holder certain rights a common equity holder does not have), but it counts as equity.

In the Drexel-financed $487 million takeover of Warnaco in late April 1986 by a group that included Andrew Galef, the chairman of four small, diverse companies, and Linda Wachner, a former president of Max Factor and Company, Drexel almost seemed to be thumbing its nose at the regulators.

W Acquisition Corporation (WAC) represented the ultimate in the shell acquirer. Not only was WAC a shell corporation with no publicly available financial statements, but the individual bidders—who were providing only slightly more than one percent of the needed financing—were disclosing no financial statements with respect to
anybody
on the bidders' side. Indeed, it was not clear who would be in control of Warnaco, should the WAC tender offer succeed. All that was really known was that Drexel was expected to raise the financing.

At least Icahn and Perelman and Peltz had been identified bidders, with some investment in the offer through their respective vehicles; it was clear they would control, if their tenders succeeded, and they each had to disclose their business histories. But by the early spring of 1986 Drexel was telling the world (including its lawmakers and regulators, all abject) that it had ceased to matter
who
the bidders were; it was a tender offer and it was money-good, because Drexel was behind it, and that was all that mattered.

Drexel got around the Fed rule by raising half the financing as common and preferred stock and the other half as debt. Following the announcement of the merger agreement, most of the equity financing was converted into debt. So much for the Fed.

I
T WAS NO WONDER
that by the fall of 1986 the Drexel juggernaut seemed unstoppable. Congress had been quieted. The takeover debate would continue—but in academia, not in the halls of Congress. And the Fed's action had been rendered impotent.

“The force in this country buying high-yield securities has overpowered all regulation,” Milken had announced to a group of pension-fund managers and others in April 1986, as reported in
The Washington Post.
“The investors have recognized increased value, and those financial institutions who dare to move into this area have been well rewarded.” Indeed. Free of any constraints, Milken's machine was working like a dream. And his critics, many of whom had been prophesying a debt-triggered doomsday for the last two years or so, were twisting in the wind.

One of the most thoughtful was James Grant, editor of
Grant's Interest Rate Observer,
who had carved out his anti-junk position back in September 1984. Grant explained that he had reached this point of view, first, because the world even at that time was long on debt and short on equity, and he followed the old investment adage that one should own the thing in short supply and shun the thing in surplus. What an illiquid world needs is cash, he reasoned, and so the debt security to own (if one chooses to own debt at all) is the one with the highest ratio of cash flow to interest expense—not, in other words, the junk securities of companies which typically have little financial leeway.

Second, Grant reasoned that the holdings of junk bonds were so concentrated in a handful of institutions (Milken's inner circle)—which issued bonds and bought each other's paper—as to invalidate
the argument of safety through diversification in one's portfolio. And, third, he declared that the junk idea had been carried too far, and that a faddishness had grown around its progenitor and prose-lytizer, Milken. Thus, Grant declared in September 1984, “. . . our hunch is . . . that, in some basic way, junk has had its day.”

Two months later, in November 1984, when Drexel refinanced John Kluge's leveraged buyout of the Metromedia Broadcasting Corporation and issued $1.3 billion of junk bonds—then the largest junk issue ever—Grant had sounded the alarums. He quoted extensively from the prospectus, which said, in the plain, daunting language that would thenceforth become junk boilerplate, that the company might not be able to pay its investors their interest or, for that matter, their principal. Grant's concern, however, was apparently not shared by the buyers, who grabbed up the Metromedia bonds, some of which promised (if all went well) interest of 15
⁵
/
₈
percent.