EDITOR’S NOTE: The August 31, 1992, issue of National Review, set out to set the record straight about the Reagan administration’s economic record. We reprint the content of the issue here.
In the search for simple causes of the nation’s economic problems, corporate debt became a familiar scapegoat. The received opinion is that U.S. business accumulated excessive debt loads during the Eighties largely through takeovers, which also caused massive job loss. In this legend, corporate financial practice (particularly the reliance on junk bonds) was a matter of paper shuffling that produced no economic value. Debt distorted economic horizons, leading to chronic “short-termism,” and the high-yield-bond market was a “Ponzi scheme” that led to an inevitable market collapse, causing major disruptions in the financial-services industry (e.g., the S&L crisis).
This near demonic view of corporate debt and high-yield securities dates from the takeover battles of the mid 1980s. As Robert Bartley notes, “Much of the concern over leverage, finally is connected to the takeover wars, to the battle between those trying to protect old capital and those trying to build new capital.”
Basically, no one heard a peep about excessive debt or takeovers prior to the mid Eighties. In fact, the Business Roundtable and Fortune 500 companies that promoted new regulations on credit access and ownership change in the Eighties had opposed restrictions on takeovers during the Carter years when they were the only companies that were able to finance large-scale acquisitions. But by the mid Eighties, when merger-and-acquisition departments on Wall Street had discovered high-yield financing as a means to launch takeover bids, old-money firms and their white-shoe investment banks sought protection not by offering a better deal to their shareholders, but by going to courts, legislators, and regulatory bodies.
How many big oil companies wanted to see another Boone Pickens, and how many Revlons wanted to see another Ron Pearlman preaching the doctrine of market efficiency? Moreover, corporate control was not the only area where entrenched and protected managers were losing ground. Market share in major industries was being eroded by entrepreneurial newcomers who deftly leveraged growth through what was then the lowest cost of capital-debt. How many more Bill McGowans and MCIs could AT&T stand? How interested were CBS and ABC/Capital Cities in seeing Ted Turner or TCI or MTV coming into their markets? Whether the assault on corporate power appeared in the form of a takeover bid or in the form of a new, more technologically and financially adept competitor, the main cause of concern for those holding on to their seats in the corporate suites was the new channels of capital access that had been carved into the securities markets.
Demythologizing Junk Bonds
Nowhere is the gap between empirical evidence and public perception greater than in the case of high-yield securities and the capital access created in the Eighties. To demythologize the changes that occurred, we need to examine each of the distorted propositions in turn.
Myth 1: Debt destroyed jobs.
“Thousands of workers lost their jobs, companies loaded up with debt to pay for deals, profits were sacrificed to pay interest costs on the borrowings, and even so, many companies were eventually forced into bankruptcy.”
-James Stewart, Den of Thieves
When access to capital was opened up, the greatest period of job growth since World War II ensued. It is true that the largest firms eliminated jobs. However, while the 800 investment-grade firms decreased employment by 4 per cent, non-investment-grade firms increased employment by 24 per cent. Examining job loss in the Fortune 500 companies for the same period was around 2 million, while the overall economy added 12 million jobs. In my own research on high-yield companies, I found that job growth was six times higher among non-investment-grade companies than industry averages and that those companies exhibited one-third greater growth in productively, 50 per cent greater growth in sales and about three times greater growth in capital spending than U.S. industry generally.
Simply put, businesses have two ways to sustain or increase profits–increase revenues or decrease costs. Generally, in the Eighties, smaller entrepreneurial companies in growth and emergent industries (e.g., cable, health care, restructured manufacturing telecommunications) used the former strategy, while the largest established companies used the latter. Instead of focusing on R&D, new products, and new markets, larger companies focused on cutting costs, mainly by cutting their workforce.
In the Sixties and Seventies, in order to avoid being confined to their mature markets, large companies had diversified wildly, leading to industrial conglomeration. Defense companies went into mass transit and nearly out of business, steel companies went into oil, tire companies went into gas, and oil companies bought circuses and insurance companies.
The restructuring of the Eighties for the most part unwound the bad acquisitions of the previous decades, leading to a deconcentration of industries and deconglomeration of unwieldy units in unrelated lines of business. The widespread association of layoffs, shutdowns, and unemployment with this restructuring is spurious. Only 4.4 per cent of mass layoffs in the Eighties, representing 6.6 per cent of the total jobs lost in shutdowns, resulted from ownership change. In tracking 1,100 plans involved in 110 LBOs, my colleagues and I found that plants involved in management buyouts were substantially less likely to close than other plants.
Moreover, high-yield and restructured companies in sectors that were hard hit by import pressures and declining demand showed higher rates of job retention than the rest of the firms in their industry. Manufacturing companies like Mattel, Seminole Kraft, and National Can actually restored jobs in plants previously threatened by closings. We found that productivity growth was about 14 per cent higher in plants that were either divested or restructured through buyouts than other plants in the same industry. In plants with significant management participation, the difference was even greater: 20 per cent.
This is not to say that there were not some poorly structured transactions that resulted in job loss. This was particularly true in those defensive LBOs where entrenched managers took on more debt to defend against takeovers (e.g. Fruehauf). Two-thirds of the distressed credits for the Eighties were issued in the last few years of the decade, when deal-hungry merger-and-acquisition departments overpriced issued in poorly structured, fee-driven transactions. Entrepreneurial buyouts that added strategic economic value became superseded in the LBO market by defensive, financially driven buyouts, in which failed management maintained its empire with an undercapitalized, overleveraged financial structure.
The lack of job growth in the Nineties is the consequence of too little credit available for new investment, not too much. Job creation halted abruptly at the end of the Eighties when regulatory and tax measures failed to keep growth alive.
Myth 2: Junk debt financed take-overs.
“There’s nothing wrong with mergers per se, except for the junk-bond, highly leveraged, bust-up type. But if you eliminated that kind of deal, then an unfriendly takeover offer is less hostile.”
-Martin Lipton, Wachtell Lipton
Takeover waves have gone on for decades. Earlier waves of mergers and acquisitions led to increased levels of economic and industrial concentration. At the turn of the century, horizontal acquisitions led to the formation of the great trusts. In the 1920s, vertical integration built large, monolithic corporations. In the late 1960s and early 1970s companies diversified into sprawling conglomerates. What was different about the merger wave that began in 1981 was the tendency toward deconcentration.
According to the Securities and Exchange Commission, high-yield debt represented 10 per cent of tender-offer financings in the 1980s, while banks provided 73 per cent. In hostile takeovers, bank borrowing accounted for 78 per cent of the financing. Of the $215 billion raised in the high-yield market during the 1980s, 23 per cent was used to finance leveraged buyouts and repayment of LBO debt.
Most takeovers continued to be done by the largest companies, often without debt financing. The difference in the Eighties was that the largest firms now sometimes faced smaller competitors in these acquisition bids. However, LBO acquisitions never exceeded 25 per cent of the total value of merger-and-acquisition activity. Big companies made the majority of offers for other big and small companies.
Of the top 100 transactions of all time (hostile and friendly), only 14 per cent used high-yield financing; the rest were done by large domestic or foreign corporations with no debt financing. The first recorded hostile takeover was done in 1974 by International Nickel Co. of Canada under the financial advice of Morgan Stanley & Co. with no debt financing. By the early Eighties, law firms and investment banks saw new potential deal flow in takeovers.
Ironically, many of the most visible debt bashers came from these firms. Martin Lipton built a profitable practice in the takeover market by offering target firms the chance to pay his firm a pre-emptive retainer to ensure that his services would not be used by corporate raiders. Similarly, Felix Rohatyn (who referred to high-yield securities as “securities swill”) and his firm, Lazard Freres, built an important practice defending against takeovers. By the end of the decade, Lazard was issuing junk bonds to fund a “White Squire” fund for the sole purpose of providing equity capital to managers facing potential takeovers.
Myth 3: Debt destroyed value.
” . . . an army of business buccaneers began buying, selling, and trading companies the way most Americans buy, sell, and trade knick-knacks at a yard sale. They borrowed money to destroy, not to build. They constructed financial houses of cards, then vanished before they collapsed.”
-Barlett and Steele, Philadelphia
Inquirer, October 20, 1991
This myth has done a great deal to damage capital markets, companies, job creation, competitiveness, and communities in the Nineties. Based on misinformation about the past decade, regulators and financial institutions have redlined whole industries and communities, creating a credit crunch that caused and prolonged the recession and dampened the current cyclical recovery.
The origins of credit expansion in the Eighties go back to the last credit crunch of 1974, when companies learned that they could not take bank financing for granted. New industries in services, communications, health, and science needed money to grow. Older industries, such as automobiles, farm equipment, mining, and steel, needed huge sums to rebuild. Simultaneously, investors sought higher yields after disappointing results in the mid Seventies. Unlike traditional lenders (such as banks and savings-and-loans), money managers in insurance companies and mutual funds were able to make investment decisions without the restrictions that come with government subsidy or guarantee.
In the convergence of corporate need for long-term, fixed-rate capital and investor need for higher returns, the non-investment-grade debt market emerged. Of the $215 billion of high yield debt issued in the 1980s, 77 per cent was used for growing or rebuilding firms. Some of the most innovative and creative industries of the last decade were financed in this market, including home building, low-cost pharmaceuticals, health care, cable television, long-distance services, and cellular communications.
The use of traditional accounting standards that focus only on book values, original costs, and historical performance fail to reflect an enterprise’s potential. According to U.S. Federal Reserve data, the market value of non-financial U.S. companies as of January 1, 1970, exceeded their debt by more than $300 billion. During the next five years, values would decline, so that by 1974, debt actually exceeded equity by nearly $20 billion, even though corporations weren’t necessarily borrowing more. The recovery of stocks, which began in 1975, stimulated equity values to rise $180 billion relative to debt over the balance of the Seventies. Still, by the end of the decade, equity exceeded debt by only $160 billion, well below the level of the previous decade.
The recovery of equity securities in the latter half of the 1970s laid the groundwork for a tripling of stock-market values in the 1980s, from $1 trillion to more than $3.2 trillion. This dramatic turnaround resulted in equity exceeding debt by over $1.2 trillion in non-financial companies, a near eightfold increase from $160 billion in 1979.
The perception of excessive debt comes from confounding historical book/cost account measures that are snapshots of the past with market values in a dynamically growing marketplace. Traditional and conventional methods measured cost, not value – yesterday, not tomorrow. During the Eighties, investors purchased over $6 billion in securities from companies in the fields of cable, cellular communications, entertainment, and health care. By the end of the decade, the combined equity market value of those firms was over $15 billion, even though they collectively had reported no net income. Such investments were based on the promise of the future.
Examples of value-creating business strategies abound also among firms that faced rebuilding. Northwest Industries was an investment-grade company that was purchased in 1985 through a leveraged buyout by Farley Industries and subsequently down-graded. In 1987, its Fruit of the Loom subsidiary was taken public in a $553 million stock and bond offering. Fruit of the Loom increased its debt, but the additional capital allowed it to expand capital spending, create new jobs, and increase sales by $2 million.
In 1988, Duracell was the battery division of Kraft Inc., a AAA-rated company. That year Duracell was sold to a group that included management and outside investors. Duracell found itself a leveraged, non-investment-grade company that no longer enjoyed ready access to inexpensive capital through Kraft. But Duracell’s president realized that it wasn’t debt that had inhibited the company’s growth, it was being owned by a cheese company. Through innovation in new products and marketing, Duracell was able to increase annual pre-tax earnings nearly sixfold, from $39 million at the time of its buyout to $226 million by the end of 1990.
As Michael Milken once put it, “The true test of any financier is not to structure securities for companies in good times, but to help find solutions to problems for companies in tough times.” In manufacturing and energy industries hit by the collapse of prices in the early Eighties, exchange offers allowed companies to swap high-coupon debt issues for lower-coupon debt issues or equity. Access to interest-rate and currency swaps, futures, and options also afforded new opportunities in debt management. Regrettably, tax-code and regulatory changes in the late Eighties began to restrict these financial innovations and reduced the capacity of companies to adapt to changing market conditions.
Myth 4: Innovative debt instruments were wampum; the market was a “Ponzi scheme.”
“Evidence now suggests that Mr. Milken’s theory was wrong–and that he was far from the genius he seemed to be about junk bonds . . . When the past decade is taken as a whole, junk bonds appear to have been a mediocre investment.”
-Wall Street Journal,
November 20, 1990
During most of the post-World War II period, inflation was low and interest rates were stable. Financial innovation was largely unnecessary.
With increased global competition and volatility of interest rates, currencies, and equity prices, companies required flexibility to change their corporate capital structure for varying conditions. Investors also needed flexibility in their portfolio management. While most people think of finance inbinary categories–either debt or equity–the 1980s saw a broad spectrum of innovative securities. Examples included zero-coupon bonds used by McCaw Cellular to build up its network, and convertible preferred bonds issued by Warner and Chrysler.
But the best known innovation is high-yield debt securities. According to the dominant media perception, the securities were the province of a small network of financiers, who “controlled” and “manipulated” the debt market. As early as 1968, there were over 6,700 bond issues listed on the New York and American Bond Exchanges, with the highest volume being traded in non-investment-grade issues. Over the past twenty years, high-yield securities were sold by more than 200 different investment-banking firms, which underwrote over 1,500 issues. There were 200 market-makers trading these bonds in the secondary marketplace. Over 100 law firms representing underwriters or issuers issued opinions on the validity of these transactions. All of the large accounting firms audited these transactions. Major mutual funds, pension funds, financial institutions, foreign investors, and individuals invested in these markets. From 1980 to 1990 the number of high-yield mutual funds grew from 26 to 83. In short, the debt market was hardly a shell game, but a complex market that matured over the 1980s.
How did investors fare during this period? For the ten years from 1981 to 1991, the high-yield market averaged returns of 14.1 per cent, outperforming ten-year Treasury bills (10.4 per cent) and the Dow Jones Industrial Average (12.9 per cent). Unlike a Ponzi scheme, the high-yield market rebounded last year to be the best-performing securities once again. In 1991, new issues rose to $9.9 billion, from $1.4 billion in 1990. Non-investment-grade companies raised $11.5 billion in the equity markets. Mutual funds that had fled the market returned with $3.65 billion of new investments, more than offsetting their total outflow for 1990. In short, between the time the alleged “Ponzi scheme” collapsed and the present, the high-yield debt market re-surged by $80 billion in value.
Into the Nineties
The fear and loathing aroused by debt in the 1980s is an anomaly in the long sweep of U.S. history. Despite Calvinistic abjurance of debt, the extension of credit, in a nation where economic growth was not held captive by inherited wealth or seigneurial rights, became the central means of access to productive assets, which, together with operating skills, talent, and hard work, have produced enormous wealth and income. With the cauterizing of new flows of capital, the economy’s capacity to respond to change has atrophied. The companies and communities that created the most jobs during the past decade are not being redlined. Young companies eager for growth capital are strapped, and whole sections of the country are threatened by the capital cut-off that began as a credit crunch and now threatens greater financial disruptions. The total dollar volumes of commercial and industrial loans dropped sharply in 1991, after edging down in 1990. Decreased lending has restricted expansion plans and polarized recovery for many economic sectors. A shorthand way of understanding this is that big business and big government (with sometimes blind and self-destructive cheerleading by big labor) sought to limit and regulate economic competition, not sustain it.
Our future depends on our ability to learn from the past, not distort it. The Eighties were a period of enormously created financial innovation. Perhaps by demystifying debt in the Eighties, we can learn to apply our new financial and economic tools to build the future instead of compulsively destroying the gains of the past.
–At the time of this writing Mr. Yago is Director of the Economic Research Bureau at the W. Averell Harriman School for Management and Policy at SUNY-Stony Brook.