Insider role or not, Drexel may see junk-bond strength fading
The insider-trading inquiry quietly continues - and an almost visible cloud of suspicion swirls tightly around the Drexel Burnham Lambert skyscraper at 60 Broad Street. Several key Drexel employees, including junk bond czar Michael R. Milken, are reported to be among some 40 to 50 Wall Street players being subpoenaed by the government.
A subpoena is not a sign of wrongdoing. Drexel has not been accused of anything illegal. But Drexel has been in the forefront of almost every major takeover battle in recent years. This has primarily been through the issuance of junk bonds, which are high-interest, high-risk notes and are often used to finance stock purchases in takeovers. And Drexel worked closely with arbitrager Ivan F. Boesky on a number of occasions.
So Wall Street can't help wondering: Will Drexel or its stars be tainted by the probe? Could the junk bond market survive the loss of Mr. Milken? Could competitors pick up the slack?
Such speculation has already prompted First Chicago Corporation to pare its holdings of junk bonds. Other banks and insurance firms are watching Drexel's junk bond inventory for signs of trouble in selling the high-yield securities. Drexel itself recently decided to forgo a move to posher quarters, citing tax law changes and Boesky-related distractions.
The bad press and gossip have hurt. Twice since the Boesky imbroglio broke on Nov. 14, Drexel has had to deny rumors that Milken had left. The firm has not lost any established clients, but ``I think there has been some harm done on the new-business side,'' Drexel's chief executive officer, Frederick H. Joseph, said recently.
Competitors are ``licking their chops'' over this, says Edward Altman, a New York University professor, consultant, and author of a new book, ``Investing in Junk Bonds.''
In the four years before 1986, Drexel underwrote 55 to 65 percent of all nonconvertible, low-grade, high-yield debt. This year, its share has dropped to about 46 percent.
And in the last three months, according to Dr. Altman, Drexel has garnered only 26.6 percent of the new junk bond business. Morgan Stanley captured 21.2 percent of the action - ``which means the market was getting more competitive even before Boesky broke,'' Altman says. ``My guess is that will continue as more players get established.''
But when it comes to mega-deals, nobody does it better than Drexel.
``I don't think any organization has demonstrated the capacity to raise the amounts of capital that Drexel has,'' says Joseph Rice, president of Clayton Dubilier, a New York leveraged-buyout firm.
Salomon Brothers is facing a crucial test of its junk bond underwriting talents in placing $800 million in high-yield debt to finance a management-led buyout of Revco D.S. Inc. Drexel has done six larger deals, including $2.5 billion for Beatrice Foods. But for Salomon, it's the biggest ever, and its success (or failure) could influence future junk bond forays.
Merrill Lynch and First Boston have also put together the financing for a couple of large deals recently, but unlike Drexel they have had to put up their own capital as bridge loans.
``When the funds come out of the firm's own net capital [which must be kept at certain levels by law], that has to limit their capacity to do deals,'' Mr. Rice says. ``Drexel can do a variety of large deals virtually simultaneously.''
The key to Drexel's strength is the network of wealthy buyers Milken has cultivated over the years. Indeed, the $120 billion junk bond market was pioneered almost single-handedly by Milken's Beverly Hills, Calif., operation.
Junk bonds have been the rocket powering Drexel's rapid ascent from relative obscurity to one of biggest firms on Wall Street. Revenues this year are expected to hit $4 billion, up from just $600 million five years ago. The firm has diversified considerably, and profits have doubled since last year, reaching $550 million in 1986.
Drexel has amassed $1.7 billion in capital, but if the firm itself were somehow implicated by the Boesky scandal, fines or lawsuits could have an impact. And Drexel would need that capital if it had to maintain a market in a junk bond panic.
Mr. Joseph says he's been assured that the federal investigators are after individuals, not the firm. But no one denies that if Milken were to leave Drexel, for whatever reason, the gap would be enormous. Drexel pays Milken an estimated $30 million to $40 million annually. Without him, Drexel's revenues might drop by one-quarter to one-third, Joseph said in a recent interview in Fortune magazine.
It would also be a stinging blow to the entire junk bond market, given Drexel's prominence. But most analysts believe it would be a short-lived problem.
``The junk bond market has advanced to a point where it's beyond damage by any one individual or any one firm,'' says Robert S. Wail, senior vice-president of corporate bond research at L.F. Rothschild, Unterberg, Towbin. ``I couldn't say that five years ago, but I can now.''
Still, some institutional buyers are waiting to see how all this pans out, and some large takeovers have been shelved. As a result, spreads between junk bonds and more-conservative investments have widened. Junk bond yields have risen in the last month from 4 to 5 percent above Treasury bonds to about 6 percent.
But it's not clear whether the rise is due to concern about Drexel, to a year-end rush that's creating an oversupply, or to some lower-than-normal-quality bonds coming to market now. Drexel officials point out they have done $1.5 billion in deals over the last week or two. Although there are reports Drexel has struggled with some recent deals, it hasn't reneged on a ``highly confident'' letter yet.
(Drexel secures commitments from bond buyers before issuing a letter telling the suitor in a takeover play that it is ``highly confident'' it can pull together the financing if the bid succeeds. Much of Drexel's reputation has been built on that assurance.)
Meanwhile, individual investors don't appear to be worried enough to abandon the double-digit yields offered by junk bond mutual funds.
``At the moment, I don't see a substantial reaction, but all the evidence isn't out yet,'' says Michael Lipper of Lipper Analytical Services, which tracks mutual fund performance. ``The key point is that we haven't seen an increase in the default rate recently; therefore, people are still getting a good return.''