Having tested the waters and found them lucrative, investment bankers are diving wing tips and all into waves of financial innovations that rise far above their traditional role as financial intermediaries.
Not many years ago, Wall Streeters who bet even a tiny fraction of their firm`s capital to take equity positions in corporate buyouts were considered pioneers. But the returns on those bets, reaching 40 percent and higher, proved irresistible.
Moreover, the popularity of high-yield, ”junk” bonds with institutional investors and takeover artists spurred the rapid deployment of me-too products by investment bankers eager to follow the king of junk–Drexel Burnham Lambert Inc.
Today, investment bankers and their pension fund and insurance company clients are scambling to amass pools of debt and equity capital to finance buyouts, spinoffs, restructurings and the rest of the menu of corporate finance. That`s a principal reason the market for corporate control hasn`t cooled as some had predicted late last year.
And so, for example, Merrill Lynch & Co. this summer is the proprietor of 200 East Coast supermarkets and Morgan Stanley & Co. Inc. is in the textile business.
Investment banks in the U.S. used to underwrite and trade securities, advise and counsel clients and broker corporate securities transactions. Now, increasingly, they also are holders of securities looking for capital gains and yield as well as transaction income.
In this regard, U.S. investment bankers have become more like European merchant bankers who traditionally hold stakes in companies and sit on corporate boards.
Bridge financing, the term sometimes used to describe this role, implies that investment bankers aren`t taking indefinite stakes in operating companies. But critics argue that bankers are endangering their firm`s financial security by gambling that they can turn around and sell high-yield bonds, or the company`s assets, to pay themselves back.
Critics also say investment bankers have neither the temperaments nor the skills to own and restructure companies. Defenders of the new role contend that no one is better equipped to understand opportunity and risk than investment bankers.
Given the innovative and highly competitive Wall Street battlefield, bridge financing probably would have come along anyway. But the impetus was the stranglehold Drexel had on the junk bond market. Drexel created the market a decade ago. Its ”highly confident” letters, indicating that cash was close at hand, had become a virtual guarantee of financing a leveraged buyout or a hostile takeover.
”We had become so proficient at it,” said Leon Black, director of mergers and acquisitions at Drexel, ”the marketplace believed anytime we said we could finance something, the financing was there. To compete, they had to come up with a better mousetrap.”
Merrill Lynch generally gets the credit for inventing the better trap. The equity stakes Merrill took in the early 1980s in the buyouts of such companies as Axia Inc. and Signode Industries Inc. produced phenomenal results, and the firm decided to systematically get into the business, setting up Merrill Lynch Capital Partners as its deal financing pool.
”Those successes have produced a full-blown commitment,” said Robert Mancuso, cochairman of Merrill Lynch Capital Partners.
In the last two years, virtually all of the big firms have joined the fray.
Though bridge financing is often used to fund hostile takeovers, that isn`t its only application, points out William E. Mayer, managing director of First Boston. The money First Boston put up last year enabled Campeau Corp. to take over Allied Stores Corp. in a hostile deal.
But First Boston also has proposed a bridge deal to defend Harcourt Brace Jovanovich Inc. against a hostile offer by British publisher Robert Maxwell; has arranged bridge financing for a recapitalization of Union Carbide Corp.; and has financed a friendly leveraged buyout when Union Carbide spun off its First Brands unit.
The amount of investment bank capital invested in many of these mega-deals bothers some critics, who contend that tying up all that money in what has been a bullish financial environment could come back to haunt the firms when the environment turns hostile.
The risks include potential conflicts with clients, insufficient credit analysis and liquidity–that is, being able to get over the bridge.
Harvard Business School Professor Samuel Hayes III says the trend reflects ”the increased importance of M&A (mergers and acquisitions) as a generator of high revenue vis-a-vis the more traditional underwriting.” But he added: ”I don`t think they have the skills to do this.”
The big risk, said Hayes, is that they are assuming ”a capital exposure in a business whose long-term prosperity they don`t understand. They are newcomers in this area, and they are vulnerable to mistakes.”
Hayes` fellow professor, Michael E. Porter, called investment bankers
”transaction-oriented financial engineers” who say to a client: ” `You tell us what you want done, and we will make it happen.` They have not asked: `Does this make sense? Is this the right thing to do?` ”
Those are the kinds of questions that must be asked when capital is risked, he said.
Not just academicians are worried. James P. Gorter, a partner at Goldman, Sachs & Co., voiced his concern earlier this year at an industry forum. He questioned whether his colleagues fully understand the risks and can handle the potential conflicts.
But Peter Solomon, vice chairman, investment banking, for Shearson Lehman Brothers, called conflicts the ”sine qua non” of investment banking and added: ”Any business that deals with people and markets is inherently risky.”
He said bridge financing entails the same credit analysis that Shearson would undertake for a traditional securities underwriting.
”You have to build in a little more risk,” Solomon acknowledged,
”because risk is a function of time. It`s the same church, different pew.”
First Boston`s Mayer agreed. ”This is just an extension of our business. That`s how we get paid. We manage risk.”
Whether a firm is in a merchant banking role or an underwriting role, the financial analysis is the same, agreed Barry Friedberg, senior vice president and director of investment banking at Merrill Lynch. ”When an investment bank takes on a client,” he added, ”it has both the professional and legal responsibility to exercise due diligence.”
Indeed, many investment bankers say the bridges in bridge financings are getting shorter as they seek more rapidly to remarket deals in an uncertain interest rate environment.
And Mayer said: ”I`ve been here 20 years and I`ve been dealing with conflicts for 20 years. Bridge loans are risky, so what else is new?”
Dennis J. Friedman, managing director at Kidder, Peabody & Co., thinks the problem arises because of image. ”People think of investment bankers as hired guns,” he said. ”We`re not hired guns. We always did a bit more than people gave us credit for doing.”
Investment bankers disagree on the future of bridge financing. ”I think they are an effective tool,” said Drexel`s Black, ”and will stay around so long as no one gets burned. But sooner or later, someone will get burned very badly.”
He added: ”There is too much capital chasing too few good deals. Some of these deals will come back to haunt the marketplace. In the last nine months, the high-yield bond market has been a relatively easy place to be but that will change when the marketplace changes.”
That is the big question mark, said Friedman. ”Can people bail out of their deals? Before we commit the bridge, we have to figure out how to get out of it. We don`t want a bridge to nowhere.”
Asked what is the worst case scenario, Mayer said: ”You make the bridge. Then the markets collapse. The value is altered downward. You own it. You`ve got $500 million tied up in this thing, and it has to be operated as a business.” He added: ”And the real worst case is you didn`t do due diligence. It goes into bankruptcy and then you`re just another creditor.”
”It is too soon to predict what will happen,” said Merrill Lynch`s Friedberg. ”These opportunities only exist in an M&A context. To the extent there is a sharp drop in M&A activity for regulatory or economic reasons, I don`t know if it will continue.”
A decade from now, Friedman predicts, ”you will find very few investment banks that are not part of larger institutions.” Access to capital is critical, he said. ”To be a full-service firm, you have to be able to put up the capital and take the risks.”
”It takes more than capital,” said Solomon. ”It takes talent and judgment. Just because our competitors have the capital, that doesn`t mean they`re going to fare successfully in this business.”
Friedberg echoed that view. ”There are human limits on our abilities to process the opportunities. The demand is probably exceeding the industry`s ability to supply human talent.”
