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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Bank debt was replaced by junk bonds as the source of outside moneyElsewhere, Long and Ravenscraft (1993b) reported that while LBOs led to substantially improved operating performance, the gains faded after three years, and that four to five years after the buyout the firm was back where it started. But despite the operating improvement, the interest burden took a big bite, leaving net profits after debt service below pre-LBO levels. Again, thats perfectly consistent with the Wall Street-fattening strategy, but has little to do with fostering a social renaissance. In a study of 124 large buyouts between 1980 and 1989, Steven Kaplan and Jeremy Stein (1993) came to several fundamental conclusions: (1) prices rose relative to underlying profits or cash flow as the decade proceeded; (2) bank principal repayment requirements stiffened, leading to less of a cash cushion for interest payments; (3) bank debt was replaced by junk bonds as the source of outside money; (4) management teams and dealmakers took ever-larger fees up front; and (5) deals struck later in the decade were far more likely to experience distress default or bankrupcy than those consummated in the early years. Only one of the 41 1980-84 buyouts they studied experienced distress, but 30 of 83 (36%) of the 1985-89 deals did many of them despite cost-cutting and improved operating profitability. Too much debt can ruin even the best business, but after 1985, these deals were far from good. This broad picture of 1980s M&A, drawn mainly from detailed studies of individual deals, is confirmed by economy-wide data as well. Going into the 1980s, corporate America was deeply undervalued. The stockonly version of Tobins q ratio (the value of equity divided by underlying tangible assets) averaged 34% between 1974, the depth of the post-OPEC bear market, and 1982, the year the great 1980s bull market began, just over half its historical average.19 As the decade wore on, however, the q rose sharply to 47% in 1986, and 60% in 1989, when the leverage boom ended (flow of funds data). Mergers have continued since at even higher qs, but with nowhere near the degree of leverage; youd have to be insane or have a high tolerance of risk, to put it more coolly to borrow heavily to pay prices like 1996s. Cash and stock are the currency of 1990s deals; firms still have plenty of free cash flow. The mergers may not work out in the long run, but at least they wont leave any debt tailings that could turn toxic over time; only the stockholders are at risk. Deals became more overpriced and riskier at the same time the commitments of managers and financiers to the deals were weakening. High up-front fees encourage irresponsible deal making book the deal now, the hell with long-term prospects. Tighter repayment schedules meant that asset sales selling off pieces of a company rather than improvements in profitability were central to the financing strategy the very definition of Minskys Ponzi financial structure. The inferior performance of the public junk bond market suggests that bank lenders are better judges of credit than are mutual fund managers and other portfolio jugglers. The whole picture of bigger, dumber deals as the buyout binge matured is a severe blow to notions of efficient markets; the whole affair with leverage looks in retrospect like one of the great financial bubbles of all time. But it was a bubble with a flossy intellectual pedigree, deep support from the government (both the elected one and the Federal Reserve) and financial establishment, and with damaging consequences to the real U.S. economy. None of the perpetrators investment bankers, finance academics, or central bankers have suffered any blow to their prestige. And none of the governance issues raised by Jensen and his comrades have been solved; we know now that the LBO association hasnt become the new model of business organization, but shareholders are still conniving to get a bigger share of corporate cash flow. detour: on Felix I said earlier that liberals and populists denounced the buyout mania as an outburst of greed without analyzing any of its underlying mechanisms. One of their favorite voices of outrage was a Wall Streeter, the soulful banker, Felix Rohatyn, whose position presumably gave him some authority, an authority that couldnt survive a serious confrontation with his rsum. Rohatyn author of tedious, moralizing pieces in the New York Review of Books, supplier of sermon-like quotes to press hacks, failed perennial Democratic candidate for Treasury Secretary, and now something of a has-been was actually the inspiration for one of the 1980s dashingest figures, Joe Perella. Perella, partner with Bruce Bid em Up Wasserman in one of the great buyout machines of the time, told Institutional Investor in 1984: I saw Felix knocking off those mergers at $1 million a clip, with no capital. I was impressed not only with his skill but also by the sheer potential of M&A fees (quoted in Henwood 1990). Felix, together with his mentor Andr Meyer, put together ITT and other great 1960s conglomerates at Lazard Frres. Rohatyn and Meyer helped turn Steve Ross from a parking-lot operator into the capo of Warner Bros. Lazard was the first to break the $1 million banking fee, but Meyer wanted nothing to do with the mundane business of underwriting securities to finance real companies; he liked playing with whole companies better. In 1963, Meyer, with his taste for the sure thing, bought a French company operating in Wyoming named, appropriately enough, Franco Wyoming, liquidated it and fired all the employees and practically overnight made a 300% profit. A name-brand investment bank bought a company, busted it up, and got away with a huge profit and its reputation intact; this was a lesson not lost on Wall Street (Reich 1983, pp. 243-247). Later, Rohatyn would denounce such practices and urge the creation of a Reconstruction Finance Corporation to retool America. A dealmaker who did virtually nothing to fund productive investment, Rohatyn frequently urged the government to take on the mundane business of industrial finance, clearly too demeaning a task for the sophisticates of Wall Street. As the novelist-polemicist Michael Thomas put it (personal communication), Felix pounds the pulpit with one hand and endorses checks with the other. going bust As the 1980s faded, it became clear that the LBO association was not about to replace the public corporation. Despite a burst of M&A activity in the mid-1990s after a lull early in the decade, the dominant transaction was a merger between large public corporations, or the absorption of one unit of a public corporation by another public corporation. A new form of rentier assertiveness came forward in the 1990s as the boutiques and lone operators faded shareholder activism. Jensen and his ilk blame the collapse of the buyout movement on regulators and the media. By jailing Milken, busting Drexel, and reining in the S&Ls, these spoilsports snuffed the only hope for the restructuring of corporate America. In fact, the movement did itself in. A wave of defaults in 1988 and 1989 followed by the near implosion of the U.S. economy in the early 1990s scared all but the loopiest away from experiments in leverage. In an interview, Jensen expressed great regret that Drexel was not around to finance Kirk Kerkorians spring 1995 attempt to take over Chrysler. Kerkorian said the automaker was sitting on piles of cash, but Chrysler defended itself by saying it was husbanding resources for the next recession. Jensen said that if Kerkorian had succeeded, debt would have sucked away this cash, which has made Chrysler management fat, bloated, dumb, and happy. With less cash, the firm would shut inefficient plants (which it should do rather than increase capacity, despite robust demand), and drive a harder bargain with labor and suppliers. To Jensen, Chryslers greatest moments were when it was near death, and was driven by fear to invent great new efficiencies.20 (Of course, a loan from the U.S. government didnt hurt either.) But, alas, there was no Drexel, and bankers shied away from financing Kerkorians attack. It was a firm sign that the 1980s were still too fresh in too many minds for a revival. Maybe in five or fifteen years, but not in 1995. The main reason that the leverage strategy was so discredited is the insolvency boom graphed nearby, one of the greatest in U.S. history, rivaled only by the deflations of the late 19th century and early 1930s. Jensen himself had argued that going bust wouldnt really be much of a problem for leveraged firms; the new structure, he asserted, would give rise to the privatization of bankruptcy out-of-court arrangements among the handful of players in an LBO, a contrast with the usual big, expensive court fight between fragmented groups of creditors and shareholders. A study by the New York Fed made this observation on the insolvency boom: Evidence suggests that in 1990-92, U.S. corporations found managing their debt in a period of weak cash flows more difficult than anticipated. Perhaps managers took seriously the argument that highly leveraged firms with weak cash flows could generally reorganize their debt without resorting to bankruptcy (Remolona et al. 1992-93, p. 3). The last sentence is marked by a footnote to congressional testimony by Jensen. Actually, Jensen seems to have had half, or maybe a quarter, of a point on bankruptcys privatization. While statistics on the costs of bankruptcy are surprisingly hard to come by, one study of corporate insolvencies between 1986 and 1993 (Betker 1995) showed that the cost of a classic Chapter 11 corporate bankruptcy averaged 3.93% of pre-bankruptcy assets, but an LBO or similar leveraged restructuring of the Jensenite sort generally knocked about 1.3 percentage points off the total. Still, all these restructurings whether a classic Chapter 11 or an intimate Jensen-style affair still left leveraged firms under heavy debt. Many 1980s deals went through two bankruptcies. Rajesh Aggharwal (1995) argued that that happened because creditors were unwilling to forgive enough debt to make a firm viable; they feared that if they forgave, someone else (like a nonparticipating creditor) would gain what they lost. The failure of the LBO movement to transform the fundamental nature of the corporate form left shareholders at a bit of a loss. Not satisfied with one of the great long-term bull markets in U.S. history, they continued to whine about unlocking shareholder value hidden in the crevices of corporate America. Since leverage turned out to be a very risky way of liberating those hidden dollars, a new strategy was in order. As the decade turned, that strategy turned out to be shareholder activism. Ironically, one of the early signs of the new activism was the antiapartheid movements pressure on universities, churches, public pension funds, and other institutional investors to sell the shares of firms doing business in South Africa. This was a marked departure from the classic passivity of institutional shareholders. But the entirely laudable goal of using financial weapons to end official racism was then quickly eclipsed by more mundane concerns pressing tired managements to liven up their companies and thereby drive the stock price northwards. A curious personal tale of the evolution of the new financial assertiveness is the career of T. Boone Pickens, who was one of the commandantes of the first wave of the shareholder rebellion. His stab at Gulf was one of the great early moments of the deal decade. During the 1980s, Pickens made relentless fun of CEOs like Andrew Sigler, the boss of Champion International who was managerial Americas mouthpiece while the likes of Pickens were wilding their way across the corporate landscape. While Sigler argued that society owned firms, not shareholders, Pickens countered that shareholder value was all. His oil company didnt really drill much he preferred to explore for oil on the New York Stock Exchange, by buying up other companies with borrowed money (Henwood 1987). Companies that tried to block takeovers with poison pills and other schemes were Pickens great enemies.21 But in 1995, Mesa found itself under attack by hostile suitors including Pickens former sidekick David Batchelder. Rather than take his own medicine, Pickens had the board adopt a poison pill. Mesas arguments sound like Siglers a decade earlier the outside group was in it just for a quick buck. Pickens defense: his days of trying to take over other companies were long gone and that he hated to be called a corporate raider. The last time I was involved in a deal was almost 10 years ago, he said. Theres no way anybody could characterize me as anything other than a hard working oilman (Myerson 1995b). Hard work neednt guarantee reward; between 1985 and 1995, Mesas stock fell 63%, while the overall market rose 171%. By Pickens own standard, he was a disgrace. He was finally ousted in 1996. Pickens was behind an attempt to organize small shareholders into a formal pressure group, the United Shareholders Association, cutely abbreviated USA. From its 1986 founding to its 1993 dissolution, USA tracked the performance of large public corporations and compiled a Target 50 list of losers. The USA would try to negotiate with the underperformers, urging them to slim down, undo anti-takeover provisions, and just deliver their shareholders more value. If satisfaction wasnt forthcoming, USA would ask its 65,000 members to sponsor shareholder resolutions to change governance structures. USA-inspired resolutions were often co-sponsored by groups like the California Public Employees Retirement System (Calpers), the College Retirement Equities Fund (CREF), and the New York City Employees Retirement System (Nycers). In a measure of the smallness of economists minds, one study discovered that in the two-day event window [after its announcement]the average USA-sponsored agreement results in an abnormal stock price reaction of approximately 0.9%. This abnormal return represents a gain in shareholder wealth of approximately $54 million (Strickland, Wiles, and Zenner 1994). In tiny steps does progress come. USA was dissolved by its board because as its president, Ralph Whitworth, put it, it was not USAs goal to stay around indefinitely as a corporate watchdog activism organization. Boone Pickens founded USA in the spirit of change an organization that would set goals, take action, and get things done (Strickland, Wiles, and Zenner 1994). This suggests that even with visibility, membership, and funding, its near impossible to get small, dispersed shareholders to act as a unit. It may pay a big-time raider to play this game, but certainly not small holders, and apparently not even small holders banded together. In 1995, Whitworth joined with Pickens former associate Batchelder to form Relational Investors, a San Diego-based fund designed to invest in poorly performing companies and act as a catalyst for change. They were backed by a number of large institutional investors, including Calpers, the most prominent of the shareholder activists. Press reports explain that this move is part of a new phase in Calpers corporate governance program, a way of pressing underperformers to change their ways of doing business. This, it seems, is the model for the mid-1990s. The heirs of Pickens are now the prowling agents of public pension funds, looking for value, ready to prod more than pounce.22 |
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