Junk-Bond Finance

To the Editors:

Felix Rohatyn (“The Blight on Wall Street,” NYR, March 12) is deeply concerned, as am I, with the “excesses in the financial community,” and, more specifically, with “the implications for the economy of the present level of corporate takeover activity, with particular attention to potentially dangerous levels of corporate borrowing.” In his view, the weaknesses in the economy have been exacerbated if not caused by an increase in “unsound financial structures,” often the result of hostile takeovers or raids financed by so-called junk bonds. Among other things, therefore, he would like to limit the issuance of less than investment grade, high-yield bonds (through restrictions on their purchasers) thereby constraining hostile takeovers.

To be sure the takeover process has been marked by excessive greed and perhaps excessive borrowing, but refashioning laws and regulations to limit junk-bond financing may be an excessive reaction. Takeovers occur largely because of the inefficient use of productive assets. To the extent that this is true, they are a corrective response to at least some aspects of our economic problems. Those like Rohatyn who call for restrictions on junk bonds and highly leveraged, often hostile takeovers must seriously confront the thesis that these developments, like the rise in foreign competition, arise at least in part because of the ineffective stewardship of US productive assets by non-owner managers, a thesis which partly explains the economy’s paucity of productive investments as well.

Since at least the 1930s economists and sociologists such as Thorstein Veblen, Adolf Berle and Gardiner Means, R.A. Gordon, Carl Kaysen, John Kenneth Galbraith, William Baumol, Robin Marris and Oliver Williamson have argued that the growing separation of corporate ownership and control permitted non-owner managers of American corporations to sacrifice profit and efficiency to other goals, for example their personal security and aggrandizement. Furthermore, oligopolistic market structures afforded American corporations leeway to pursue these additional objectives. Indeed, writing in the late 1950s, Kaysen characterized the modern corporation as one “in which the constraints imposed by market forces are loose, and the scope for managerial choice is considerable.”

In such an environment, economic “natural selection” cannot ensure profit maximization and economic efficiency. Thus, foreign competition and the takeover threat, or what Henry Manne has termed the “market for corporate control,” become increasingly important enforcers of market discipline; both are encouraged by the profligate use of corporate resources. Although Rohatyn thinks that the contention that raiders are enforcing capitalist discipline is “a canard,” Nobel laureate James Meade correctly observed twenty years ago that, “a company which sacrifices profit either to an easy life or to unprofitable growth makes itself liable to a take-over bid.”

Junk-bond financing of hostile takeovers is a critical element in the maturation of the market for corporate control because it gives raiders unprecedented access to capital. Michael Milken of Drexel Burnham Lambert, originator of the junk-bond market, was exaggerating only slightly when he emphasized in a speech last year that ideas and people rather than capital were now the economy’s scarce resource. By providing a relatively liquid market for junk bonds, Milken and Drexel effectively removed a major impediment to investment, since the higher yields on junk bonds compensated for the additional risk. As a result, these relative outsiders in the Wall Street and corporate communities became the dominant financial players of recent times. Their clients, also largely outsiders, were able to accumulate substantial wealth and establish significant ownership interests within corporate America. The vitriolic reaction to the excesses that accompanied their meteoric rise is hardly surprising.

I have been arguing that divergence from profit-maximizing behavior because of poor managerial accountability to shareholders (which is at least in part the result of limited stock ownership and distorted incentive structures) creates opportunities for profitable takeovers, and that highly leveraged financial structures enable a broader universe of acquirers, including raiders, to capitalize on these opportunities. Sometimes the pressure of actual or potential takeovers leads management to do the same thing that raiders would do. Such corporate restructurings, recapitalizations or mergers with “white knights,” unlike the payment of “greenmail” to save managers’ jobs, are ultimately motivated by the same “straightforward economic forces” as the takeovers themselves.

While it is too soon to fully assess the profitability of recent takeover activity, particularly, as Rohatyn correctly emphasizes, given the apparent lack of fundamental strength in the economy and the sensitivity of highly leveraged acquisitions to the business cycle, anecdotal evidence and case histories strongly support the view that it has been highly effective. These include hostile takeovers such as Ronald Perelman’s takeover of Revlon and defensive recapitalizations such as Union Carbide’s escape from GAF Corporation. Some of the most dramatic success stories, such as William Simon and Raymond Chambers’ purchase of Gibson Greetings from RCA, have been negotiated leveraged buyouts. What has made these acquisitions successful, in addition to their impeccable timing in relation to the business cycle, has been the active participation of the new owners, if not in day-to-day operations then in strategic and financial planning and in the establishment of a system of accountability and profit-oriented incentives for top management, often through substantial equity interests in the enterprise.

On the other hand, there is a substantial empirical literature dealing with the effectiveness and profitability of the more “conservatively financed,” largely friendly mergers and acquisitions which predominated before the 1980s and which Rohatyn seems to favor. Although the results are inconclusive, they seem to show that such mergers had been at best a marginal investment.

While the proliferation of leveraged acquisitions is in my opinion a fundamentally healthy development, the process may have proceeded too far, particularly given the precarious state of the economy. In this regard, I share many of Rohatyn’s concerns. It does not follow, however, that regulatory bodies will be better able to control the degree of leverage in the economy than will market forces (and it is certainly rash to suggest, as Rohatyn does, that reduced oil exploration efforts are the result solely of highly leveraged balance sheets rather than dramatically lower oil prices). Business failures may occur as a consequence of excessive leverage in a weak business environment but it is hard to imagine that such outcomes can be prevented by regulation without doing more harm to the economy. Indeed, the current proliferation of leveraged acquisitions may be a reaction to the deleterious effects of a period of underleveraging of our productive assets.

Governments do, however, have an affirmative obligation to ensure a “level playing field” for investors and in this regard, many of Rohatyn’s recommendations about shareholder democracy and the abolition of greenmail are apt and would be especially potent if they were not conditioned upon curbing junk-bond finance. Humane governments also have an obligation to protect innocent victims of business failures and the economic cycle, including depositors in thrift institutions and beneficiaries of pension funds which have been large purchasers of junk bonds. Still, it does not follow that restricting the issuance of junk bonds is the most efficient means of discharging this governmental obligation.

It has long been maintained in the banking literature, for example, that the present flatrate system of deposit insurance encourages excessive risk-taking by insured institutions. Insurance rates linked to the degree of risk in an institution’s portfolio, on the other hand, would produce a lower and less distorted degree of leverage in the economy. Such an approach to the risks attendant to the proliferation of junk-bond financed hostile takeovers, as well as to the banking system’s exposure to the debt of less developed countries, is more flexible and efficient than the outright limitations Rohatyn advocates.

Roger E. Alcaly

K.D. Equities

New York City

Felix Rohatyn replies:

One of the major economic risks facing this country is the excessive use of debt at every level. Personal debt, corporate debt, and government debt have all grown much more rapidly than the economy. The recent action by Citicorp, increasing its loan reserves by $3 billion in order to recognize their problems with third world debt, should serve as an illuminating example. The excessive use of junk bonds over the last few years is not different in principle from the excessive lending to third world countries by the commercial banking system in the 1970s. Of course it is true that some third world loans are sound; and it is also true, as I wrote, that as a result of takeovers financed by junk bonds “some companies may be leaner and more competitive.” But in both cases the overall debt is excessive and very dangerous and in both cases the results will generally be the same. They will be painful to the acquirers of the debt, destructive to the borrowers, and, ultimately, paid for in good part by the US taxpayers.