In response to:

Greed from the March 29, 1990 issue

To the Editors:

As a lawyer practicing in Paris in the area of international mergers and acquisitions, I share Michael Thomas’ view that many LBOs are a fraud against the US taxpayer [“Greed,” NYR, March 29]. However, Thomas’ policy criticism of the US tax system is based on a faulty premise. Thomas contends that interest paid on junk bonds should not be deductible because “not a penny actually changes hands.” This is factually incorrect. LBOs are financed by borrowing from banks, insurance companies, little old ladies, and other holders of junk bonds. The interest paid on these bonds clearly “changes hands.”

In fact, the current focus in the popular press on junk financing misses the mark. Now that investors in search of ever higher interest rates have realized that junk bonds are a risky investment, they will buy fewer of them. While this development may finally put Mike Milken and his friends out of business, it will not stop the LBO mania.

The essential ingredient of every LBO (which the cognoscenti have surprisingly succeeded in keeping secret) is not junk financing but rather that the target company’s hard assets (plant, real estate, equipment, inventory) may be pledged or mortgaged to secure a considerable portion of the acquisition financing. It is this possibility of taking a mortgage that induces “respectable” banks to participate in LBOs.

Perhaps a lesson can be learned from French law. In France, as in the US, interest on acquisition indebtedness is deductible for tax purposes against the operating income of the target. However, French law draws a fundamental distinction between the mortgaging of a company’s assets to secure a loan used to acquire a new plant or a new subsidiary, and the mortgaging of a company’s assets to secure a loan used in effect to acquire its own shares or assets. US banks would be far more reluctant to participate in dubious LBOs if the US adopted the French principle that the target company’s assets may not be pledged or mortgaged to secure indebtedness used to purchase the target company’s own shares.

William E. Krisel
Paris, France

Michael M Thomas replies:

Mr. Krisel and I are both right. In the interests of simplification (a book review should not read like a securities prospectus), I used the phrase “junk financing” in reference primarily to those securities which pay interest-in-kind (PIK). Such securities accrue interest, but do not actually pay it out in cash. Instead, additions are made to the amount owed, or adjustments are made in certain conversion and option features, but the issuing company is spared the onus of writing out checks.
Subject to recent changes in the tax law (which do not apply, however, to RJR Nabisco), junk bond issuers could deduct these interest accruals as if paid in cash, which is nothing less than a swindle on the taxpayer. My main point is that such securities (in RJR Nabisco, approximately $6 billion, or close to a quarter of the transaction value) permit overbidding to an egregious extent since the cash flow of the target company need not be sufficient to service the debt being piled on.

The upper tranches of LBO debt, which can include high-yield term securities that technically could be termed “junk,” pay interest in cash as due. To that extent, Mr. Krisel is correct in calling me to task for a loose definition (actually too narrow a use of the adjective). May I add that bank loans, which he includes, are emphatically not “junk”—for the time being anyway.

As for his suggestion that we adopt the French proscription against second-time-around mortgaging, it’s a fine idea—were it not for the fact that (a) very little present junk is secured by mortgages and (b) perhaps more important, there are at present several thousand, at a minimum, highly paid corporate lawyers adept at turning public proscriptions against financial trickery into private prescriptions for profit. Even I, no lawyer, can think of at least one way around the French approach.

This Issue

June 28, 1990