Just as private equity dominates news headlines today, the masters of the Wall Street universe 20 years ago were an investment bank (Drexel Burnham Lambert) and a form of debt with which the firm had become inextricably linked (the junk bond). They were fabulously successful for nearly 10 years, but Drexel’s high yield empire didn’t last. Greed set in. America’s corporate establishment became angry. There was envy on the Street and the government felt sufficiently pressured to prosecute. Ultimately, Drexel and Michael Milken were severely punished. But the junk bond survived to see another day and, in 2007, high-yield debt is thriving.
Are there any lessons in how Drexel saved future junk bonds that could ensure private equity is a respected investment strategy for years to come?
Let’s be clear, I’m not predicting Drexel’s fate for any private equity firm. But there are ominous signs that some are looking for blood – intense media scrutiny questioning every mega buyout deal, excess attention to the extraordinary wealth generated by private equity’s titans, an IRS ready to tax carry as income and a U.S. Justice Department inquiry searching for evidence of anti-competitive behavior. What in the Drexel experience could be usefully re-purposed by the private equity industry today?
For those too young to remember events of the late 80s, here’s a brief recap. Mike Milken was the first to create a market for investors in junk bonds and pioneered their use in leveraged buyouts and as growth capital for companies in new industries struggling to finance ideas. It was these innovations that by 1988 led to billions being issued in junk bonds, making Drexel the most profitable investment bank on Wall Street. Drexel and Milken’s undoing came when they started to use junk bonds to finance acquisitions and hostile takeovers. The raids and the corporate raiders being sponsored rattled the establishment of corporate America and in 1989, the SEC brought enforcement actions against Drexel and Mike Milken. Drexel settled 6 felony counts for $650 million and in 1990 filed for bankruptcy. Milken was sentenced to 10 years in jail (only served less than two) and paid $900 million in fines.
While the heat of the SEC’s investigation was on, Drexel launched a full scale image campaign to assume greater control of public debate and save itself and the reputation of junk bonds. Titled Financing America’s Future, the campaign told the story of how junk bonds had revitalized the American economy. Through an ambitious advertising and PR effort – estimated to have annual costs of $25 million at the height of battle — Drexel made sure America understood that it had financed more than 1,000 companies, many of them new pioneering companies such as CNN, MCI, McCaw Cellular and Warner Communications (now Time Warner.) It told as many people as would listen that the firm had provided much needed financing to former icons, known as fallen angels, that couldn’t get a bank to look, let alone finance them. (Chrysler and Mattel were resuscitated with high yield finance.) The campaign broadcast that from 1980 to 1986, companies using junk bonds had accounted for 82 percent of the average annual job growth at public companies and added jobs at six times the average rate in each industry. It said that these companies had brought new cable, healthcare and day care services to the American public and technologies such as cellular phones.
The effort did nothing to save Drexel’s hide, but the campaign was highly effective at saving junk bonds. According to Thomson Financial, 2006 was a record year for high yield debt with proceeds of $152 billion and the fourth quarter the biggest on record. And the events of the late 80s had little, if any, negative impact on the long-term careers of many senior executives at Drexel. Well-known Drexel alumni include Abby Joseph Cohen (Goldman Sachs), Leon Black (Apollo Advisors) Todd Fisher, (Senior Partner at Kohlberg Kravis Roberts & Co) and Ken Moelis (who recently left UBS as head of investment banking to start his own firm).
The lesson for the private equity industry is this: Just like Drexel, it needs to take back control over how the story is told and communicate the benefits of a robust private equity industry. It cannot allow itself to be defined solely by carry, collusion, management fees and dividend recaps. Rather, it needs to talk about how private equity investments have enabled companies, removed from the glare of quarterly scrutiny as public companies, to re-strategize and rebuild, and the benefits to the economy of such reinvigoration.
A recent AT Kearney study suggests how the story could be told. It found that private equity investors created one million new jobs in Europe over the past four years and 600,000 in the US, with PE-financed companies on average generating employment at a much faster pace than comparable, traditionally financed companies. The survey also indicated broader economic benefits in terms of R&D, profitable growth and international development. And the industry shouldn’t forget to remind the general public, particularly those who might be teachers, nurses and state workers, that they are the people benefiting from the double-digit returns enjoyed by public pension funds that invest in private equity.
George Bernard Shaw once said that what we learn from history is that man cannot learn from history.
But if the private equity industry is smart enough to make annualized gross returns in excess of 20%, it’s got to be smart enough to know there’s something it can learn from Drexel’s history – perhaps a campaign titled, “Private Equity — Investing in America’s Future”?