Drexel Burnham Lambert's competitive advantages in leveraged buyouts and junk bonds

Predator's Ball

There were a few different financial innovations that were mentioned in the book. One was the leveraged buyout. This is when a management team, along with what were termed "corporate raiders" would take out a high level of debt in order to buy out the company. The use of leverage to buy out a company would often leave the company with insufficient cash flow to cover its debts, a situation to be solved by effectively gutting the company -- cutting people and assets in order to generate cash flow. Further, there was relatively little equity left in the business, and the creditors would end up owning the company. The creditors were the "raiders" who had lent the management team the money to buy out the company in the first place. This technique was an innovation at the time because it was an unconventional, back door sort of way to acquire a firm, used when a firm was not otherwise receptive to being purchased.

Junk bonds were another innovation. A junk bond is one that is considered to be below investment grade. To compensate for the higher risk level, a junk bond must offer a much higher rate of return to investors. The key in this story was that Milken would issue bonds that were junk right from the start, as opposed to the usual situation where an investment grade bond would slip into junk status. By issuing junk bonds from the outset, the raiders would receive a high level of payments from the firm that they were seeking to acquire. The higher rate of cash flow made it more likely that the company would be forced into insolvency and that the creditors would ultimately gain control over the company. In the meantime, they would also earn a healthy return on their junk bonds. Thus, the junk bond that was issued as a junk bond was an innovation because in the past, nobody had specifically issued a bond that was junk status.

Drexel Burnham & Lambert (DBL) had a few competitive advantages that enabled it to succeed. The firm first was at the lead of the financial innovations of the time, having essentially developed or perfected the techniques associated with leveraged buyouts and junk bonds. It was more aggressive than many of the more established investment banks, for example being more active in hostile takeovers, which allowed it to gain access to opportunities that were otherwise not available to other investment banks. Milken himself had personal connections with buyers of junk bonds, something that gave Drexel unique fundraising ability with this investment class, that could not be matched even by other investment banks. So part of the competitive advantage was simply the strategy that the company employed, which its leaders had designed, and part of the advantage lay with the culture of the firm, which was aggressive and rewarded such aggressive behavior with compensation.

Drexel was driving some of the changes in the industry environment with its tactics. Other firms were in particular threatened by the legal implications of having a culture like Drexel's, and were therefore wary of adopting a similar strategy. The bargaining power of Drexel expanded with its early successes, however, and the company started to gain competitive advantage by virtue of this success.

Milken is not described especially favorably in the book. He is described for his aggressive personality, relative disregard for the law, and as a hyper competitive person who was both brilliant and aggressive. Milken ran his company in a manner that matched his personality. His aggressive nature was both a strength and a weakness, the latter because it led him to break laws, and allow others under his watch to do so as well. Another strength was his intelligence, as he was able to devise many financial innovations, and his contacts were another strength that the firm leveraged. Two other weaknesses were hubris, which made him vulnerable to mistakes, and his lack of ethics -- he destroyed a lot of companies and lives, which brought him more scrutiny from the law than would otherwise have occurred.