While Michael Milken is obviously a controversial person, that he was and is influential is impossible to argue. Anyone who wants to learn more about Michael Milken, including the parts of his life that sent him to jail can read Fall from Grace, The Predators’ Ball, Den of Thieves or A License to Steal. Links to these books can be found below in the Notes as is usual. This is a blog post about finance and not about history or ethics.
A few short sentences provide context for people who do not know who he is: “Starting in 1969, when he joined the firm that would become Drexel Burnham Lambert, Milken helped finance thousands of companies.” In his book How the Markets Really Work former Harvard Business Review editor Joel Kurtzman wrote “Milken’s real contribution was to get investors to understand that the stock and bond markets were not really separate markets. Milken created a tremendous pool of liquidity.”
Michael Milken’s financing methods brought new approaches to the financial markets focused “on cash flow rather than reported earnings; and second, to consider human capital part of the balance sheet. He played this out by backing such pioneers as Bill McGowan (telecommunications), Ted Turner (cable television), Craig McCaw (mobile phones), Steve Wynn (resorts), Len Riggio (book retailing) and Bob Toll (homebuilding).” He also financed T. Boone Pickens, Saul Steinberg, Carl Icahn, and Ronald Perelman. The Economist magazine writes:
“While a student at Berkeley in the late 1960s, Mr. Milken came across empirical support for his hunch that a portfolio of these high-yield bonds would outperform an investment-grade portfolio, even taking into account the higher likelihood of default…. The interest-rate spread over supposedly safer bonds was more than enough compensation for the higher expected losses…. Junk-bond issues also offered a new way for many small but growing firms, which had been starved of capital by stodgy commercial banks and sniffy investment banks, to finance themselves…. [Ken Moelis said] Mike Milken started out in the 1970s when capitalism was struggling. In those days, there was very little innovation. Along comes Drexel and suddenly you could get capital….Before 1977, when new junk-bond issues took off, …non-investment-grade bonds were thought of as “bad” investments, at any price. Nowadays a bad credit can be considered a prudent investment if it is available at the right price…. The Hollywood business model is a search for a blockbuster that will pay for all the turkeys. High-yield bond investment is a different art: the trick is to avoid the losers; then the winners will take care of themselves.” http://www.economist.com/node/17306419
I am going to omit the usual line item commentary in this blog post and instead make some general comments up front. One time
His advice was often unconventional and often quite insightful. Once when I was part of a team raising money for a startup, Michael Milken advised us to focus in raising money from people who recently became wealthy. He said that “old money” is far too attached to it and will turn down good investments for that reason. “Focus on the recently rich when trying to get new investors,” he said.
While this is a post about Milken, most of what I learned about finance I learned from many different people. I feel lucky to have known each of them. Among the biggest lessons I have learned in finance from these people are: (1) you can have massive wealth in terms of assets and yet sometimes in the short run you can have no cash; (2) cash is the oxygen of business and (3) running out of cash is the only unforgivable sin in business. Assets that are not liquid trade at a discount for a very good reason.
Another lesson I learned is that a business with an ability to raise billions of dollars in debt on one day may not be able to raise five cents a day later. Credit markets can literally change direction overnight. And precisely when that happens is not predictable. For that reason having a margin of safety on cash is very wise. Cash can have tremendous optionality when things go wrong in the markets. But dry power in the form of cash has real costs (negative arbitrage). Getting the mix right, is tricky and depends on the company, industry, business cycle industry and economy. Here’s Milken on this point:
“When your business depends on technology – whether it’s aerospace, computer and electronics firms in the 1960s or Internet, telecom and networking companies in the 1990s – volatility is a fact of life. Unlike slower-changing industries like supermarkets, which can appropriately assemble a balance sheet with more debt, technology is an inherently risky business and needs a strong balance sheet to survive. In fact, risk in capital structure should vary inversely with business risk.” “The decision to increase or decrease leverage depends on market conditions and investors’ receptivity to debt. The period from the late-1970s to the mid-1980s generally favored debt financing. Then, in the late ’80s, equity market values rose above the replacement costs of such balance-sheet assets as plants and equipment for the first time in 15 years. It was a signal to deleverage.”
Ratings from the ratings firms obviously fail for the reasons noted by Milken below. The conflicts of interest in the bond rating business continue to this day. I would rather put a viper down my shirt that buy a bond simply based on a rating. In an article on Milken Vanity Fair described the core of the problem: “the rating services are paid by the companies who issue the securities they rate. Moreover, the rating services admit in their fine print that their ratings are based on the data supplied by the companies seeking the ratings.” http://www.vanityfair.com/online/daily/2009/01/was-mike-milken-rightafter-all-1
Michael Milken points out below that “book value” reveals very little about the operations of a business and does not distinguish between cash in an account and a business with assets, products and loyal customers. Milken discovered this fact and others have since used it to raise massive amounts of money.
A smart CFO I worked with for many years used to say: “If you want to understand better what credit quality actually is, watch how the bank debt is trading. Bank debt is senior and the banks have deeper information based on stronger covenants. They are an early warning system.” Speaking of CFOs, a great one is a pleasure to watch work, particularly in a capital intensive business. Milken is correct that financing is an art and a great CFO is an artist.
Also an artist is someone like Howard Marks who earns his financial returns in no small part from his deep understanding distressed bonds. https://25iq.com/2013/07/30/a-dozen-things-ive-learned-about-investing-from-howard-marks/ This is a great summary of what he does from Marks himself: “Our mantra is “good company, bad balance sheet,” which is different from a bad company; those can be challenging to turn around. But if you have a good company with the wrong balance sheet, that’s easier to fix. How do good companies become financially distressed? The answer is they take on more debt than it turns out they can service in tougher times.” Marks and several other successful people like Ken Moelis and Rich Handler at one time worked for Milken.
One interesting thing about debt is how some people are comfortable having loads of it. Even being billions of dollar in debt does not stop them from sleeping like a baby. It was J. Paul Getty who once said: “If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.” Perhaps that is the right explanation for some people’s comfort with having loads of debt.
People can argue about the nature of Michael Milken’s legacy, but there is no question he had huge influence on finance and business.
1. “Financing is an art form. One of the challenges is how to correctly finance a company. In certain periods of time, more covenants need to be put into deals. You have to be sure the company has the right covenant — to allow it the freedom to grow, but also to insure the integrity of the credit. Sometimes a company should issue convertible bonds instead of straight bonds. Sometimes it should issue preferred stock. Each company and each financing is different, and the process can’t be imitative.”
2. “It grates me to call them “junk bonds” … they are a debt instrument that trades more on the underlying credit risk of the company or the industry than on movements in interest rates. They have legal characteristics of debt, but if things go bad you’re generally the first creditor to take on the rights of an equity owner.”
3. “Rating is not credit. Long-term ratings have not been a good predictor of credit quality among different sectors of the world economy. So you shouldn’t invest based on ratings.” “There are only half a dozen U.S. companies with a triple-A credit rating. Yet, in 2007, rating agencies gave almost 1,300 financial instruments triple-A ratings. They never legitimately deserved triple-A ratings, but that rating enabled the leverage that created the problem. People got comfortable with the rating rather than doing their own homework on credit quality.”
4. “Book value alone is not usually a good measure of the future.”
5. “Debt isn’t good. Debt isn’t bad. For some companies, close to zero debt is too much leverage. For other companies, nearly 100 percent much higher levels of debt can easily be absorbed.”
6. “The right time for a company to finance its growth is not when it needs capital, but rather when the market is most receptive to providing capital.”
7. “Credit is what counts, not leverage. If you’re leveraged eight or 10 to one in an asset class that declines by five to 10 percent, you don’t have staying power in a mark-to-market world.”
8. “Most people who’ve accumulated a great deal of wealth haven’t had that as their goal at all. Wealth is only a by-product, not the original motivation.”
9. “The past is always triple-A. We can all remember what the past was. But if we try to make the future triple-A, we have no future. The future is always single-B.”
10. “The best credit by far, history has shown, has been the private company. Sovereign countries have defaulted 30 times as often as private companies, both domestically and foreign. Individuals default five times as often as private companies.”
11. “The year 1974 taught me that leverage can decimate even the best company when its access to capital is cut off. It also taught me that most people have short memories. That’s why most financial people have five-year careers – one market cycle.” “Bankruptcy isn’t an end. It’s an opportunity to build a more suitable financial structure.’”
12. “You get full points for telling me things before they happen, not afterward.” (said to Myron Scholes at the 2008 Milken Conference). “Interest rates are never predictable. The idea of borrowing short and lending long is simply not a business.”
Milken Quotes: http://www.mikemilken.com/quotes.taf