A debate is raging in Washington and on Wall Street over whether to restrict the use of a powerful technique called "junk-bond financing" that rapidly is adding billions of dollars of debt to the balance sheets of corporations that are targets of takeover bids.
Unless there are immediate restrictions on the use of this financing technique in attempted hostile takeovers, many corporations will be too heavily laden with debt to survive the next recession, and the nation's financial system will be weakened, some financial experts warn.
Sen. Pete Domenici (R-N.M.) has introduced a bill that would impose a moratorium through December 1985 on hostile takeovers financed with junk bonds.
"What is happening is similar in some ways to speculative abuses that led to the 1929 crash," said Nicholas F. Brady, chairman of Dillon, Read & Co., a New York investment banking firm. "These activities represent an abuse of the system that is among the most serious I've seen in 30 years. Speculative, highly leveraged financing techniques involving junk takeover bonds, if unchecked, will leave misery in their wake.
" . . . . Nobody is smart enough to 100-percent leverage a company and withstand a recession. We're going to see a wave of defaults. Do we wait until there is blood all over the floor to do anything about this?"
What are junk bonds, and who are the creative financiers using them to launch multibillion-dollar hostile takeover bids for some of America's best known corporations?
Junk bonds are high-yield securities, dubbed "junk" because of the low ratings they get from the agencies that rate bonds. The bonds frequently are listed as "below investment grade," which means the rating agencies believe they carry a relatively high level of risk for investors.
The junk-bond market is changing rapidly. It used to consist mainly of bonds issued by corporations and public utilities that were considered to be investment grade before financial difficulties led to their downgrading.
But the dramatic growth in the junk market recently has come from bonds issued by young, emerging companies and bonds issued to finance hostile takeover bids by corporate raiders, including T. Boone Pickens Jr. and Carl Icahn. It is the use of the bonds in highly leveraged, hostile takeover bids which is causing most of the controversy.
To get an idea of the magnitude of their use, consider the following: An aide to Domenici estimates that more than $14 billion in junk bonds are being proposed in takeover bids for companies including CBS Inc., Unocal Corp., Uniroyal Inc., Crown Zellerbach Corp., Hilton Hotels Corp., American Natural Resources Co. and National Can Corp. Almost $16 billion in high-yielding junk bonds was issued in 1984, and about $36 billion was issued in the 1977-1984 period.
Here's how a junk-bond-financed takeover bid works: Bonds are issued by a shell corporation created as the vehicle for a hostile-takeover attempt. Usually, the Wall Street investment banking firm of Drexel, Burnham Lambert Inc., the leader in junk-bond financing, arranges the sale of the bonds on behalf of a corporate raider such as Pickens or Icahn.
The bonds are sold to a group of investors, which includes other corporate raiders, some savings and loan institutions, some foreign banks, certain insurance companies and some of the world's wealthiest investors.
Recent junk-bond offerings have been sold to Canada's Belzberg family, Saul Steinberg, Carl Lindner, Charles Knapp, Meshulam Riklis, Victor Posner and the Bass brothers, a formidable list of aggressive investors.
These investors earn substantial commitment fees for agreeing to buy the bonds, fees that they earn even if they never are called on to actually purchase the bonds. The bonds are secured by the assets of the company the raiders are going after. The raiders launch their buyout bid with the intention of paying off the debt through cash generated by the target company's operations or through the sale of assets.
Some junk-bond offerings, such as Ted Turner's proposal to buy CBS, are known as "bust-up" takeovers, because a large part of a company's assets would have to be sold to finance the buyout.
The power of the junk-bond phenomena is that takeover bids that once could be launched only by giant corporations, with financing provided by banks, now can be launched by individuals such as Jacobs, Pickens and Icahn, with Drexel Burnham selling the bonds to its list of aggressive investors.
If the raiders are successful in gaining control of the company, frequently they bust it up and sell off the assets, hoping to make a profit on the difference between what they paid for the whole corporation and what they can get by selling it in pieces.
If the raider does not gain control, it frequently is because the corporation ends up being acquired by another company, which adds debt on its books to make the purchase as it saves the company from the raiders. Alternatively, the target corporation can escape the raiders, as Phillips Petroleum did, by adding billions of dollars in debt to its balance sheet as part of a plan to increase its stock price.
Whatever the outcome, once the company is "put into play," or becomes the target of a junk-bond-financed takeover bid, the target inevitably ends up highly leveraged, with significant amounts of new debt on its books.
Junk bonds are appealing because they typically pay 3 to 4 percentage points above government bonds and high-grade corporate bonds. Academic studies have concluded that, even after deducting for bankruptcies, over long periods of times a portfolio of low-quality bonds yields better returns for investors than high-quality bonds.
Motivated by the opportunity for higher yields, portfolio managers in New York and Los Angeles are investing billions of dollars in junk bonds, confidently insisting that they have found a way to consistently achieve superior returns.
According to these managers, what they receive through the higher interest rates more than compensates them for the greater risk they take by investing in junk bonds. They say this is true even though they do not know how to assess the risk of the bonds without Drexel's guidance and even though many of the bonds appear to be unsecured or thinly backed by company assets.
Junk-bond investors say they are overcompensated because the supply of these bonds exceeds the demand from investors willing to take the risk of buying them.
Many institutional money managers are afraid that if they invest in junk bonds and suffer losses, they will be sued for failing to be prudent managers. Many money managers avoid the market because it is not as liquid as the market for highly rated bonds and because reliable information on transactions is not always widely available.
Diversification is the key to consistently getting superior returns by investing in these bonds, according to these portfolio managers and Drexel Burnham. That limits the impact of any single bad investment.
A recent study by New York University finance professor Edward I. Altman found that the default rate on junk bonds during the past decade was 1.6 percent a year, or about 20 times higher than the 0.08 percent default rate on all corporate debt. But Altman said that despite the relatively high default rate on the bonds, their overall returns have been an impressive 5 percentage points over long-term government bonds in the period he studied.
A recent study of junk bonds by Wharton finance professors Marshall E. Blume and Donald B. Keim found that the risk of a well-diversified portfolio of low-grade bonds was no more, and perhaps less, than the portfolio of AAA corporate bonds, given the high yields from junk bonds.
But the effect of the junk-bond trend worries some experts.
"In general, this country and the world's economy is being papered over with debt, whether it is Third World debt, leveraged-buyout debt, junk-bond debt, or repo debt," said Felix Rohatyn, a senior partner of Lazard, Freres & Co. "We are stripping our economy of equity and replacing it with debt."