The Era of Junk Equity

The easy access to capital provided to Internet companies, which I recently wrote about, reminds me of the days of Mike Milken and junk-bond financing.

Back in the 1970s, the emerging early telecom market was closed. AT&T (T), the regional Bells and the government-run Post, Telephone and Telegraphs had an ironclad grip on business and on the regulators that controlled the growth of that business. That made it difficult for the new cable and long-distance bypass companies to gain access to the capital markets. They couldn't sell equity: No one would buy it. They couldn't borrow money from banks: They were considered riskier than Third World debt. For them, borrowing via extremely high-yield bond financings was the only way to go.

So they borrowed at what many considered onerous interest rates -- 12%, 16%, 18% or higher -- via high-yield debt instruments issued by Mike Milken and Drexel Burnham Lambert. At rates like that, even the mob blushes, but Milken created a liquid market for the debt of lower-grade companies. And this, in turn, allowed the institutions to trade the stuff and create a portfolio with some measurable risk of default.

The only trick was that, in order to win, TCI, Turner and MCI had to grow faster than the coupon rate on their debt. If they could do that, then junk-debt financing was better than selling equity. A guy like Ted Turner got to keep the equity and just pay back the debt out of free cash flow if -- and, fortunately for Turner, when -- cash started flowing freely. Those that didn't have cash flowing simply died quickly.

Milken and the many buyers of this junk debt saw the growth potential of these industries. They took a long-term view, put a long maturity on the bonds and convinced themselves that these were safer investments on a risk- and return-adjusted basis. It was only when junk debt began financing takeovers, in fact, that both Milken and junk financing got into trouble. That's because in many of those asset-based takeovers, there was no growth, just fat being cut out of existing corporations. If the acquirers could squeeze enough fat and cellulite out, paying 16% rates was no problem. But if they fell behind or cut expenses too far, then they failed and lost the whole bundle -- like Robert Campeau.

Now, fast-forward to the '90s. Equity markets have a much better understanding of the growth potential of technology. And because Intel (INTC) and Microsoft (MSFT), two of the most valuable companies in the world, were financed entirely by equity, an entire industry grew up around financing promising technology start-ups.

While investors were looking for the new beneficiaries of these long-term trends of cheaper semiconductors and cheaper bandwidth, the Internet came along. (If it hadn't, institutional money managers with huge inflows of fresh cash would have had to invent it!) And actually, it was investors, not Al Gore, who invented the Internet, or rather funded it: After the success of Netscape's and Amazon's (AMZN) IPOs, the floodgate opened for junk IPOs.

These were not low-quality companies, but paper-thin balance sheets and income statements. In past years, many of them wouldn't have merited a look from investors, much less funding at 25 to 100 times forward revenues; forget about forward earnings. But many start-ups with scalable Internet business models came to the public markets, and a new kind of company was born: the gigastart-up. In this era of new math, an outfit with barely $10 million in revenue would be valued at $1 billion. These were the same amounts that the long-duration clients of Mike Milken were willing to put into junk debt.

It's an entrepreneur's heaven. Who needs Milken now that public markets and the IPO window are open? Forget debt: Use junk equity. Just issue more paper at higher values and raise more cash.

Better yet, trade your paper for someone else's paper and build an empire with junk common stock. Of course, the market will guide you: Announce a deal the market doesn't like -- for instance, the Lycos (LCOS)-USA Networks (USAI) deal, and boom, you have a sagging stock and you're through doing deals. Announce one the market likes -- Yahoo! (YHOO)-GeoCities (GCTY) or Yahoo!-broadcast.com (BCST) -- and the sky's the limit.

Until investors insist on improved financial structure -- as they have recently with Amazon -- junk equity rules. For now.

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