The Truth About Takeovers
Stelzer, Irwin M.
THE VOL. 20, NO. 6 / JUNE 1987 AMERICAN SPECTATOR Irwin M. Stelzer THE TRUTH ABOUT TAKEOVERS . . . and the beauty of junk bonds. I t has now been a full year since Den- niss Levine decided to...
...These critics of entrenched managers—they can only be found on the golf courses in the afternoons, according to Darman—want managers to remain under the raiders' pressure to perform or perish...
...We are witnessing a real-life Monopoly game, still played with paper, but now called junk bonds," the chairman of Household International told the Senate Banking Committee...
...featherbedding, and the cost of strikes...
...The very existence of these "predators," now backed by performance-oriented institutional investors and investment bankers prepared to market billions of dollars of so-called junk bonds, causes managers to work harder to increase returns to shareholders who, after all, own the company...
...The recent arrests seem to show that the newly beefed-up and computerized surveillance systems are working well, catching the crooks...
...They know that corporate debt is made to seem artificially high by the fact that it is stated in current dollars, while the value of assets such as plant and equipment is stated in historic pre-inflation dollars...
...bitragers, investment bankers and lawyers . ." The corporate establishment's effort to use the insider trading scandals as a lever to obtain anti-takeover legislation is understandable: they want to protect their jobs, perquisites, and easy lives...
...And on one day earlier this year, five major takeovers were announced, the largest being Chrysler's $1.5 billion proposed acquisition of American Motors Corporation...
...To make takeovers more difficult would be to deprive shareholders of enormous legitimate profits in order to deprive insider traders of much smaller gains...
...215 pp...
...based on fiscal prudence...
...Enter also the LBO—the leveraged buy-out...
...Rather, they are generally IOU's of companies too small or too new to receive a technical "investment grade rating" by rating agencies...
...Takeovers, testified the chairman of Schering-Plough, are "a sickness we must all work together to cure...
...C o the insider trading cases are not 1.3 the real source of American business's discontent...
...The supposedly conservative Republican administration has attacked entrenched managements...
...Only acquirers able to line up 100 percent of their financing before making a bid should be allowed to play the game, USX's chairman added, concluding in a tone that must have warmed populist hearts on the committee, "We need to find a way to eliminate the extravagant profiteering by the financial speculators, . . . takeover specialists, arIrwin M Stelzer is director of the Energy and Environmental Policy Center of the John F Kennedy School, Harvard University, and an American correspondent for the London Sunday Times...
...20003 rV THE AMERICAN SPECTATOR JUNE 1987 15...
...Sensing that a company is not performing up to its potential, they seek control, with a view towards improving earnings of the target company, or selling off its constituent parts at prices that, in aggregate, exceed the pre-merger market value of the company as a whole...
...AMERia POORER THE COST OF LABOR LAW IA Laws that give unions a privileged status in American society cost Americans more than $100 billion a year, according to this careful study by economist Morgan Reynolds...
...Fortunately, opposition to takeovers and to junk bond financing is likely to prove ineffective in stopping efficiency-inducing takeovers...
...If Drexel does run into serious trouble with the Securities and Exchange Commission, First Boston and others will be delighted to increase their share of this lucrative market...
...Indeed, these companies are often the most rapidly growing and innovative, and have been responsible for most of the new jobs created in America in the past decade...
...But the risk of default has been more than offset by higher yields, leading most students of finance to conclude that net returns on junk bonds, after allowing for defaults, have been "very impressive...
...Neither should be a serious concern...
...This book reviews the legal privileges and immunities of labor unions...
...productivity, NN age inflexibility...
...The high levels of debt borne by the acquired companies may, they fear, cause those firms to concentrate on the short run...
...C o opposition to junk bonds is not 1...
...It succeeded because investors know a good thing when they see one: the return on these junk bonds is attractive even in light of their higher risk...
...The value of such deals in 1986 almost reached 1985's record, according to Fortune...
...These bonds have been attacked as "the peril behind the takeover boom," creating a "casino society" and an over-leveraged business community susceptible to collapse at the first sign of recession...
...Takeovers and LBO's rely heavily on "junk bonds," which explains corporate America's opposition to these debt instruments...
...I t has now been a full year since Den- niss Levine decided to confess to the SEC about his insider trading activities, and about eight months since Ivan Boesky agreed to plead guilty to a variety of charges, and pay a $100 million fine...
...This has provided and will continue to provide the Pickenses, Goldsmiths, Icahns, Han-sons, and Perelmans with their opportunities...
...Morgan Stanley, in a 1985 study, found that the default rate on these bonds averaged 1.6 percent annually, about in line with the historic default rates for all corporate debt...
...Restricting their use would "tilt the balance of power in favor of embattled target managements . . . and hamper the market forces that lead to the replacement of poor managements and the breaking up of inefficiently large or diversified companies...
...When this slothful behavior forces the prices of their companies' stocks to fall below the value of the underlying assets, investors are saying that, in their view, those assets are worth more in the hands of other managers...
...Despite the fact that these widely publicized arrests (who can resist a story about a tearful millionaire broker being dragged from his office in pin stripes and handcuffs...
...equivalent of Gorbachev's less successful restructurerscontinue to buy up and reorganize America's corporations...
...Enter the takeover artists, BoonePickens, Lord Hanson, et al...
...All of this should make the strange new political alignments understandable...
...Commerce Secretary Malcolm Baldrige blames a good part of America's trade deficit on the corporate establishment...
...Put them on a comparable basis, give appropriate weight to cash flow and earnings, and the apparently burdensome debt often becomes manageable...
...Long ignored by underwriters, they were forced to borrow from commercial banks, often at high rates...
...As Drexel Burnham Lambert, the leading vendor of these securities, has pointed out: "Over 95 percent of all U.S...
...About two-thirds of the approximately 300 LBO's announced in 1986 were just such transactions: division managers, often mortgaging their homes to raise their share of the needed capital, buying divisions of companies and thus acquiring a direct stake in improving the efficiency of these businesses...
...The raiders will have little difficulty financing their takeovers and restructuring...
...And the 1986 junk bond default rate of 3 percent is still comfortably in line with the risk premium paid on these bonds...
...Before junk bonds became popular, notes the Federal Tkude Commission, only large companies could play the takeover game...
...This rating would be due to small size or lack of credit history, not to a lack of prospects...
...Shareholders are quite capable of taking the long view—witness the fancy prices they pay for the stocks of biotechnology and other high-tech companies...
...Despite the insider trading scandals, dealmakers—the U.S...
...Certainly, there is little logic to their position...
...Lower earnings, corporate jets, and a quiet life seem to them a more desirable combination than the pressured existence of a profit-maximizer...
...In the long run, these "corporacies" will continue to attract buyers who can more efficiently deploy their assets...
...Drexel Burnham Lambert did not successfully market billions of dollars of high-yield bonds only because its star, Michael Milken, is a super salesman...
...This would be like closing the banks in order to foil an occasional robbery...
...Junk bonds gave them a competitive alternative to the banks, prompting the latter to join their establishment brethren in the industrial sector in seeking restrictions on the use of such debt instruments...
...While less overtly hostile than some of the big deals of 1985 and earlier years, these takeovers reflect the fact that the basic conditions prompting the restructuring of America's corporations are unchanged...
...N 224 Second Street...
...SF Washington, D.C...
...although there are some such...
...There is no one to blame," he says, "but American management—not labor, not government, but management...
...Furthermore, takeovers have enormously and quite properly enriched shareholders...
...That unhappiness springs from fear—terror—that a free market in companies will increase shareholders' ability to jettison nonperforming managers...
...Not only has the default rate been only a bit higher than blue chip bonds, and no higher than that on ordinary commercial loans made by banks, but it has had minimal effect because most of these bonds are held in large, diversified portfolios, by sophisticated professionals, quite capable of refusing to buy unattractive issues—witness the difficulties faced by Carl Icahn in refinancing TWA, by Ted Timer in raising money for his takeover of MGM-UA Entertainment Company, and by the managers of the retailer Macy's in obtaining funds for their eventually successful buy-out of that company...
...In between and since, other heads have rolled, with still more charges and arrests likely...
...Junk bonds are not typically securities of companies that have fallen on hard times...
...corporations with assets of more than $25 million, if they were to apply for a bond rating, would be rated below 14 THE AMERICAN SPECTATOR JUNE 1987 investment grade...
...Because managers are often beyond the control of widely dispersed shareholders, they have little incentive to maximize the return earned on the assets under their supervision...
...This is nonsense...
...As Emory University's William Carney has pointed out, "Measured as a percentage of net worth, based on the replacement cost of assets, corporate debt at the end of 1984 was less than 60 percent of net worth—about where it was in 1958...
...Of course these newer, smaller firms must pay higher interest rates to borrow money than do older firms, since the danger of default is greater...
...They can offer shareholders a premium for their stock, sell off portions of the companies to investors or managers who can run them better, and install their own teams to manage the core businesses more efficiently...
...Available at bookstores or directly from: Cato institute, Dept...
...Supplemented by tighter internal controls on the number of people in each firm with access to sensitive information, and by the deterring effect of stiff sentences, the current system can be made sufficiently effective to keep violations of the law to a minimum...
...A deN astating critique of monopoly unionism...
...21.95 cloth/$9.95 paper/c...
...Leaders of the National Association of Manufacturers and the Business Roundtable, long opposed to hostile takeovers, trooped to Washington to appear before their new allies, Senators Metzenbaum and Proxmire...
...But to maketakeovers more difficult would be to deprive shareholders of enormous legitimate profits in order to deprive insider traders of much smaller gains...
...And it may make them more vulnerable to a business downturn...
...Richard Darman, who recently stepped down as deputy secretary of the Treasury, has called these businessmen "bloated, risk-averse, inefficient and unimaginative...
...Investors, aware that the default rate on these bonds has been more than offset by their attractive yields, and that risk can be diversified by holding a portfolio of these bonds, will continue to snap them up...
...This is a technique whereby the managers of some underperforming division of a conglomerate buy that business, using borrowed money to finance their acquisition...
...True, a few crooks have appropriated confidential information about such takeovers and used it to skim some of the profits...
...It stems from banks' desire to eliminate a competitive source of borrowed funds, and establishment industrialists' desire to reduce threats to their jobs, and to make it more difficult for new competitors to obtain financing...
...rr his leaves disinterested observers 1 with two worries...
...The first of these is the failure of many managements to slim down their conglomerates, and to concentrate on businesses they understand...
...For the sake of economic efficiency, let's hope these strange new bedfellows fail to consummate their marriage, or to produce legislation to permit corporate bureaucracies to resume the lush life of pre-raider days...
...Senators Metzenbaum, chairman of the Antitrust Subcommittee, and Proxmire, chairman of the Banking Committee, are working with the Business Roundtable and the NAM to develop legislation to make hostile takeovers harder...
...This was true before Levine and Boesky came to Wall Street and will remain true long after their departures, unless the business establishment cons Congress into passing anti-takeover legislation...
...Not only must hostile takeovers be stopped, the leaders of corporate America contend, but the use of so-called junk bonds must be curtailed...
...created a public and congressional atmosphere not exactly favorable to the business community, the establishment leadership of America's corporations was delighted...
...Supposedly liberal Democrats, on the other hand, are now siding with the business establishment...
Vol. 20 • June 1987 • No. 6
