A Bond By Any Other Name
In the spring of 1982, us bank interest rates hovered at around 17%, Kevork Hovnanian, a New Jersey-based real estate developer, began searching for long-term financing that would let his company plan future projects without having to beg banks for more and more short-term loans. Hovnanian Enterprises Inc., the $70-million, private company he had founded in the late 1960s, was borrowing some $30 million from commercial banks -- about three times its current equity. The money was being used to finance construction of more than 1,000 condominium units in southern New Jersey and Florida. But there was hardly any breathing room in the way the financing worked. For each dollar Hovnanian Enterprises borrowed, bankers asked it to pledge specific real estate and property as collateral. And Hovnanian himself, as the owner, was required to sign personal guarantees for every loan. All of the debts had to be paid back in two years or less.
The millions of dollars of secured bank debt had met the company's financial needs for years. But the requirements of the growth-minded developer were changing dramatically. "We had reached a where we wanted to be able to do the engineering and approval work for several prospective projects at once," Hovnanian notes. Ground breaking for future condo developments is sometimes a year or two after the project begins, "but we needed to be able to expand our operations and cover all those planning expenses," he says. "We needed long-term money, but we had almost no security to offer a lender. Everything we owned was committed to the banks as collateral for current projects."
While an obvious financing option might have been to sell a piece of the company's equity in an initial public offering, the depressed stock market of early 1982 had made that strategy both difficult and unappealing. "I wasn't prepared to give away part of the company," Hovnanian says. "The price would have been too low." Selling long-term debt privately to a large insurance company -- another possible route -- had similar drawbacks. With no assets to secure, "an institution would have wanted some equity. And I didn't want a partner," he explains.
The long-term financing option Hovnanian ended up choosing, however, didn't require him to give up any equity at all. Nor would it require him to put up any specific collateral or limit its ability to do other types of financings in the future. Instead, Hovnanian Enterprises opted to make its public-market debut in an unusual way. Hovnanian elected to raise $25 million of long-term capital by selling his company's bonds in the public market. Hovnanian Enterprises would remain a closely held business controlled by its founder, although it would have to report financial data to the public (see sidebar, page 78). But its 12-year bonds -- subordinated to all other debt -- would be sold to mutual funds and other diversified portfolio managers. In particular, the targeted buyers would be specialists that had lately been demonstrating a voracious appetite for the higher yields paid by smaller and lower-rated companies. In the jargon of the investment world Hovnanian Enterprises would be selling "junk bonds."
By issuing its bonds to the public, the company would have little chance of appealing to investors that insisted upon the sterling credit strength of an IBM or an AT&T -- corporations that held the highest AAA ratings of Moody's and Standard & Poor's, the established rating agencies. But it really wouldn't matter. In the diverse financial marketplace, an increasing number of other buyers had surfaced that were willing to assume higher levels of risk on their investments in exchange for the chance to earn returns of three to five percentage points higher than they usually would. At a time when many high-quality issues were being snubbed, junk-bond investors were snapping up the bonds of lowrated companies just as unknown as, and sometimes even smaller than, Hovnanian Enterprises. What is more, Kevork Hovnanian had learned from Drexel Burnham Lambert Inc., his investment banker, that not every company selling long-term debt had publicly traded stock. "We wanted the long-term money," he recalls. "And it seemed like an idea worth pursuing."
As intriguing as the approach had sounded, it also brought results. In May 1982, Hovnanian accompanied his investment bankers on a six-city tour to meet some of the nation's leading institutional buyers of junk bonds. At meetings in Los Angeles, Kansas City, Chicago, Boston, Philadelphia, and New York, the Iraq-born condominium developer described his company's niche at the moderate end of the New Jersey and Florida housing markets. "We showed off our numbers," Hovnanian recalls. "And we talked about how we keep our inventory lower than most everybody in our industry."
Evidently, the investors liked what they heard. Within a few days, Hovnanian Enterprises had raised its $25 million at an interest rate of 16 7/8%, about 4 percentage points less than it was paying on its shortterm bank loans. To qualify for its comparatively low cost of borrowing, the highly leveraged company offered bond buyers a sweetener of 3% of its pretax earnings, over and above the established interest rate. But to achieve maximum flexibility to pursue long-range expansion, Hovnanian Enterprises wasn't required to make any principal payments on the new debt for several years. Moreover, because the new debt was to be subordinate to the company's existing short-term loans, it provided a welcome layer of comfort to the banks that was almost like a new shot of equity. With the proceeds, in fact, Hovnanian Enterprises was able to pay off a lot of its bank loans. "It placed us in a much stronger financial position," Hovnanian, who is now 60, asserts. "It was a major milestone in the growth of the company."
The junk-bond market, to be sure, has been around for many years. It began attracting investor interest -- and picked up its less-than-flattering nickname -- back in the early 1970s, when nearly all of the lower-rated bonds in the market belonged to weak, or extremely leveraged, companies, such as Penn Central, LTV, and Bangor punta. But what began almost exclusively as a secondary market made up of aging corporate bonds that had been issued years before, has recently been transformed into a vastly different market. Starting in 1977, "the market began buying new debt issues of emerging companies that hadn't proven themselves to the rating agencies," notes Frederick H. Joseph, who heads Drexel Burnham's corporate finance department. It has become another avenue for smaller companies -- public and private alike -- to expansion capital.
Far from falling into the category of "junk," at least some of the companies with bond ratings of B or lower, asserts Joseph, are "the companies of the future." In keeping with this philosophy, his Wall Street firm has spent much of its time and resources over the past several years underwriting deals for growing companies. Drexel has sold public debt issues as small as $10 million. But as a practical matter, Joseph says, issues should be at least $12 million, to provide investors with confidence that there will be a secondary market if they decide to sell. To meet debt service costs on a $12-million deal, Joseph notes, a company should have aftertax earnings of about $2 million -- or at least be generating sufficient cash to support repayment. The companies issuing low-grade bonds don't always seem to be the most worthy credits. But that isn't the way Drexel views it. In the course of accepting a new client, Joseph says, "our main benchmarks aren't the company's current financial ratios but what we think about its long-term prognosis for success."
It is not surprising that the earliest low-rated bond issues to be sold in the market were for younger public companies with appetites for growth capital that went beyond their abilities to retain earnings. Among the companies that raised money this way were MCI Communications, a telecommunications company; Comdisco, a computer marketing and leasing company; and Golden Nugget, a hotel and gambling concern. Standard & Poor's and Moody's had -- and still have -- real doubts about the ability of companies rated B or lower to meet principal and interest payments on long-term debt. But Drexel, in its eagerness to create a lucrative new niche on Wall Street, was willing to look deeper.
A rating agency, Joseph contends, might give a company a rating of B or less for any number of reasons, including low reported earnings, a high debt-to-equity ratio, or even the fact that the business is small. Yet relying on these criteria alone, he says, may cause an investor to overlook the company's other key strengths, such as its impressive cash flow, market position, or record of stability and growth. Getting a handle on the less obvious credit characteristics of a business -- including the qualty of management -- can take weeks or months. "That's usually a lot longer than Moody's and S&P can justify," Joseph says. "We learned to rely on our own credit analysis." In the process, the firm's expanding team of analysts and traders were learning a lot about what institutional investors would be willing to buy (see sidebar at right). Says Joseph: "There was no reason why there couldn't be high-yield bonds for private companies."
The first smaller private company to issue long-term bonds to the public was North American Watch Corp., a New York City-based importer and distributor of Swiss-made watches, which was November, 198395 on INC.'s list of the 100 fastest-growing public companies in 1983. In May of 1979, the company raised $14 million at a fixed rate of 13 1/8%, compared with a prime rate of about 12% at the time. The $26-million business was looking for a way to refinance some of its floating-rate bank loans at a lower cost. Since virtually all of its assets were tied up in inventory and receivables, Drexel structured the 15-year deal as senior, rather than subordinated, debt -- both to provide the company with a lower interest rate and to make it less risky for investors. Although the bonds carried a speculative B-rating from Standard & Poor's, Drexel found willing buyers. "The company got long-term capital to augment its retained earnings," notes Stephen D. Weinroth, a managing director at Drexel who worked on the transaction. "And its principal payments don't start until the seventh year."
The successful North American Watch deal proved the basic hypothesis that public bonds can be sold for private companies. But on subsequent debt issues, investors have shown a willingness to settle for less senior credit status in exchange for higher yields. In one such deal in January 1981, American Sign & Indicator Corp. of Spokane, Wash., sold $25 million of 20-year bonds on a subordinated basis. The $46-million company, which leases time and temperature displays to banks, paid a fixed rate of 15%, compared with the 13% to 14% then being charged to top-rated companies. But even at that rate, says president Luke Williams, "we were better off than at the rate we were paying on our bank loans. They were up as high as 22%."
Buyers of junk bonds, however, aren't always attracted simply by interest rates on straight debt issues. During hard times in the market, companies eager to raise money are often forced to provide sweeteners that give investors participation that goes beyond the fixed rate. Among the features companies have offered have been a percentage of profits -- as Hovnanian furnished -- and warrants to buy stock.
When privately held Ackerley Communications Inc., an acquisition-minded, outdoor advertising company based in Seattle, sold its $20-million bond in the fall of 1980, for instance, the major institutional buyers were looking for long-term coupons of at least 17%. But the highly leveraged company, which, at the time, had sales of about $34 million and actually carried a negative net worth, avoided paying that rate by offering an unusual feature. In a deal designed by Drexel, investors were given a 15-year interest rate of just 13 3/4%. As added incentive, though, they got warrants that could be converted into shares of Ackerley stock -- if and when the company decides to go public. If no initial public offering takes place by 1985 -- and the company says there are no plans for any stock offering -- Ackerley has left itself an out. It will purchase the warrants from investors at their appraised market value. Says Drexel's Weinroth: "The company has preserved the option of keeping its equity private."
For Ackerley, which was in the midst of a string of acquisitions in the airport advertising and broadcasting industries, having access to any type of long-term capital was critical. Banks were pressuring the company to find sources of long-term financing to support the new properties. But a trip to the equity market would have almost surely been a disappointment, concedes president Barry Ackerley, even if the stock market had been roaring. "We're in a specialized business that's very strong in cash flow but weak in earnings." While the institutions that bought the company's bonds were able to understand the ins and outs of how the company operates, he is convinced that "equity investors would have expected us to show increasing profits every quarter. They simply wouldn't have known how to value our assets."
In the past few years, the universe of sophisticated "junk," or high-yield, bond buyers has expanded considerably. The earliest institutional buyers to become active in the market were specialized mutual funds, such as New York's First Investors Fund for Income Inc. and Boston's Fidelity High Income Fund. But they have recently been joined by the pension funds of such large corporations as Xerox, Allied, and Eastern Airlines -- a low-rated credit that sells its own debt in the junk-bond market. Such investors have been impressed by studies that show portfolios of low-rated bonds outperforming long-term U.S. Treasuries by about four full percentage points -- even after defaults -- since the late 1970s. As the market attracts more money and more buyers, at least some of these investors have been willing to purchase the debt of growing, smaller companies in industries as diverse as communications and casino gambling.
"As buyers," notes William Pike, portfolio manager of Fidelity's High Income Fund, "we're not buying one bond, but a whole portfolio." The protection he and others have taken against a bond default, moreover, isn't found in legal restrictions against an issuer, but in the higher yields -- and the knowledge that, in a pinch, they can unload their bonds. The most active secondary market for junk bonds is maintained by Drexel's high-yield bond department in Los Angeles. Before buying an issue, Fidelity's Pike says, he needs to be satisfied that the company -- public or private -- "has an excellent chance of servicing its debt and has a high enough yield to compensate for the chance that something may go wrong. But there are no assurances, so I like to know there are liquid markets."
If investors have been drawn to the junk-bond market for higher returns, so, too, have a widening circle of Wall Street investment bankers. A pioneer underwriter of lower-rated debt, Drexel has, in some years, done as many high-yield debt deals -- 25 last year -- as the rest of Wall Street combined. But others, including Merrill Lynch, Shearson/American Express, and, First Boston, have been gearing up to play more aggressively in this corner of the market. It isn't very hard to see why. Fees on these issues run from 2 1/2% to 4% of the amount being raised -- three to four times what IBM Corp., the bluest blue chip, might pay. "The whole market has become legitimatized by the institutions," says Mark Lightcap, who left E. F. Hutton & Co. last March to establish a high-yield bond department at First Boston. "It's become a place where companies can go for subordinated capital without being forced into selling equity. Once they've sold bonds, they have more short-term borrowing power."
Now that the long-term debt option is available to a broader array of companies, more and more of them are deciding to use it. In 1978, as the market was just being established, 51 issues of low-rated bonds raised a total of $1.4 billion. During the first half of 1983, however, the market provided a vehicle for more than 50 issues to raise some $5 billion, roughly twice the amount sold in all of 1982. While Wall Street investment bankers expect investor tastes to change from time to time -- sometimes preferring fixed rates to equity features, sometimes the reverse -- nobody sees the demand for high-yield issues moderating any time soon. "There's more money coming into this market than ever before," says Drexel's Joseph. "And an in creasing number of underwriters are learning how it works."