For some people the 1980s were a golden age of Wall Street. The decade saw a wondrous surge in M&A activity driven by the availability of plentiful funding for corporate raiders and private equity firms as interest rates came down and the levered loan and high yield markets developed at breakneck speed as the financial industry embarked on three decades of deregulation that some believe are the proximate cause of the 2008 Great Financial Crisis. Unlike the 1970s which were characterized by a bear market that decimated, albeit temporarily, the GoGo stocks and saw the rise of the conglomerate, the 1980s were a bonanza for activists, LBO practitioners, and corporate raiders who claimed to unlock billions of shareholder value through their deals.
The dark side of this developments in the market for corporate control in the US were the myriad cases of trading with insider information often prosecuted by a young Rudolph Giuliani. Thus Michael Milken went on to join Ivan Boesky, Dennis Levine, and Martin Siegel, among others, in Federal prison. Even Robert Freeman, the Head of the Arbitrage desk at Goldman Sachs, ended up serving four months in prison on mail fraud charges. While Giuliani was on a roll, the decade’s Minsky moment came with the downfall of Drexel Burham Lambert and the demise of Michael Milken, the billionaire head of its high yield trading desk. The Friday the 13th mini-crash on October 13, 1989 was a reaction to the undoing of the decade’s last LBO because of opposition from the unions and the ESOP. You may not believe this but the target was UAL Corporation, the parent company of United Airlines. Thank God for small mercies!
In the world of fiction, Tom Wolfe depicted Sherman McCoy in his bestselling novel The Bonfire of the Vanities as a Master of the Universe who made enough money selling bonds to live regally between his Park Avenue “mansion in the sky” and a nice place south of the Highway out East. “Shuman” might have bumped into Michael Lewis on the two-story high ceilinged Salomon Brothers trading floor as they watched how John Merriweather cleaned up John Gutfreund on an impromptu game of liar’s poker. Treasurys traders managed to stay above the fray for a while as they rode their own bull market. Just in time for the aftermath of the 1987 crash, Oliver Stone introduced America to Gordon Gekko a composite character of arbitrageurs and corporate raiders. Some Americans were shocked to learn that “Greed, for lack of a better word, is good”, others embraced these words as their guiding light and mantra. In 1987, also just in time for the crash, Donald Trump published The Art of the Deal.
The 1990s were not as kind to Gutfreund, Merriweather, or Trump. Gutfreund had to step down as Salomon Brothers Chairman and CEO in 1991 following a Treasury department investigation that revealed that Paul Mozer, a senior Treasurys trader, was submitting false bids in an attempt to buy more Treasurys than permitted. Salomon Brothers had to be rescued, stabilized might be a better choice of words, by Warren Buffett’s Berkshire Hathaway. Merriweather left Salomon in 1994 to start Long term Capital Management a hedge fund that went down in spectacular fashion just four years later in 1998. This was the first of two blow ups, as a second firm did not survive the first quarter of 2008. The 1980s relative value skills-set did not age well. By 1992, Trump’s Atlantic City casinos had filed for bankruptcy protection, following reorganization lenders obtained 50% of the equity. Trump Hotels and Casinos Resorts went public in 1992. By 2014 this company had filed for bankruptcy protection five times.
Flash forward, 30 years to the end of another prodigious decade in financial markets, and we find many familiar faces who are still around. Rudolph Giuliani, the former public prosecutor, is now ensnared in political corruption as the personal lawyer to a Donald Trump who in his first term as the 45th President of the United States has just been served articles of impeachment by the House of Representatives. Michael Milken is back as a philanthropist and a survivor of prostate cancer. Carl Icahn is still wheeling and dealing. Private Equity firms are bigger and more powerful than ever before, not only do they takeover companies, they take over entire countries as their influence on regulators and supervisors has turned the periphery of the euro zone into their most recent hunting grounds for distressed assets. They have steadfastly and cleverly influenced banking regulation until they have succeeded in acquiring tens of billions of distressed assets from zombie banks. Our guess is that they will eventually experience buyer’s regret as they have taken on too many assets, and many of them are not just distressed, but real duds.
Some of the lessons we have learned from reviewing the past may be applied to our investment process and philosophy easily. First and foremost, there is not a single good reason for an investment vehicle that provides periodic liquidity to its investors to engage in becoming a liquidity provider to the markets. Thus, we have avoided relative value like the plague. Secondly, a competitive market for corporate control is a wondrous engine for shareholders’ returns and no such market is more competitive than the US market. This coupled with American ingenuity, the best university system in the world, low taxes, business friendly labour laws, legal security, well-oiled and deep capital markets, a huge domestic private sector demand, and management accountability that has led to higher returns on invested capital; in our view more than justifies the US’s main markets’ decade old outperformance. Thirdly, at least one thing that what we learned in business school in the 1980s remains true today: investors don’t need for management to diversify across industries or in many cases across geographies as they can do that themselves far more efficiently. Finally, even as many people deride US management for their fixation on stock buy backs, we find these a far better use of our hard earned money than empire building acquisition sprees or value destroying mergers often designed with the single goal in mind of gaining size to fend off unwanted suitors.
As we are about to embark on a new decade we would like to see some of the features of US markets becoming more prevalent on this side of the Atlantic where poor management decisions are defended as long term strategic decisions. This past week, we witnessed a glimmer of hope. Unlike Telefonica, which announced a spin-off when management meant to say a sale of assets, Bankinter is spinning off to shareholders in a very tax efficient transaction its historically very profitable and successful venture into auto insurance. Bankinter was also the first company in Spain to buy back stock in the 1990s. So perhaps this is an isolated incident where an enlightened management and board come to the conclusion that there is no advantage to keeping disparate businesses under one roof, but as we approach a new year and a new decade, for some people anyways, we would like to be optimistic.
We strongly believe that European stocks will do far better in the next decade if companies stick to their core business and get rid of distractions, if management teams become far more focused on capital budgeting and far less focused on institutional relations, attempts at regulatory capture, and other popular courtly games, and finally if shareholders and directors turn a deaf ear to the siren songs promoted by bankers and management on the virtues of cross border M&A as more often than not these mergers will fail as much vaunted synergies will not reveal themselves within a human life span and yet diseconomies of complexity never fail to arise.