Clients Remain Loyal to Drexel Despite Probes

For many people on Wall Street, the next move of corporate raider Ronald O. Perelman was going to be a leading indicator--a signal of the fortunes of Drexel Burnham Lambert Inc., the investment banking firm that had served him for years in his pursuit of target companies.

For months, Drexel had been laboring under a cloud: the prospect that the federal investigation of insider trading and other corporate finance abuses on Wall Street would yield its greatest return from among some of the firm’s key employees.

Working to Get Clients

Other investment banks, including Salomon Bros., Morgan Stanley, First Boston and Shearson Lehman Bros., were working hard on Drexel’s clients. Executives at companies whose public equity or debt offerings had reached the market over Drexel’s name were receiving several calls a day from Drexel rivals.

Some were retailing the latest rumors about Drexel’s vulnerability. Others were even more blunt, telling the companies that Drexel would be unable to complete pending securities offerings.

Among the prizes was Perelman, who came to control Revlon Corp. through a Drexel-financed series of takeovers and who was known to be eager for further acquisitions.

“Watch where he goes,” one leading investment banker said about a month ago, suggesting that if Perelman hired a different investment firm to handle his next major deal, it would be a harbinger of “a gradual transition” by such corporate raiders away from Drexel.

Early in April, Perelman announced a bid for the 67% of Revlon still in public hands. The investment banker on the deal: Drexel Burnham Lambert.

Campaigns Disappointing

Perelman is not alone in demonstrating such loyalty to Drexel. Professionals at rival firms that sought to take over some of Drexel’s business have found their campaigns disappointing. “The bust-up entrepreneurs owe a tremendous debt to Drexel,” says one.

It’s more than just the “bust-up” raiders such as Perelman, Carl C. Icahn and Saul P. Steinberg--so-called because of their custom of selling off pieces of many of the companies they acquire--who owe that debt. Drexel’s clientele includes hundreds of small and growing companies that were never able to tap the public debt markets for capital until the firm perfected the original-issue “junk bond” market.

The loyalty of those clients, counterbalanced by deepening federal investigations into the firm’s relationships with such Wall Street lawbreakers as Ivan F. Boesky, helped make the first quarter of 1987 the best of times and the worst of times for Drexel.

Drexel’s success in underwriting securities in the first three months of this year placed it in or near first place in several corporate finance categories, especially the underwriting of junk bonds, where the firm enhanced its No. 1 standing by increasing its market share to 49.5% of all issues from 47.9% in the same period a year ago.

This accomplishment came at a time when the firm’s reputation continued to be tarred by the government’s investigation of illicit practices in Wall Street’s mergers-and-acquisitions community--of which Drexel has been a leading component.

The dual probes by the Securities and Exchange Commission and the Justice Department are focusing in part on the activities of Michael M. Milken, the junk bond impresario who is perhaps Drexel’s most important executive. As the developer and trader of the junk bonds that helped finance many corporate raiders, Milken was at the center of many merger transactions that are now being examined by the investigators.

Speculation that the government was continuing to aim its probe at Drexel grew when Boesky, the former stock speculator who settled SEC insider trading charges last November, pleaded guilty April 23 to a felony charge of filing false documents with the SEC.

At the core of the charge against Boesky was a stock with which Milken and Drexel were closely identified: Fischbach Corp., a New York contracting firm that was acquired in 1985 by Miami financier Victor Posner, a Drexel client, using financing assembled by Drexel. Fischbach stock, furthermore, had been actively traded by other Drexel clients in the months before Boesky started acquiring shares but still during the period in which Posner was assembling his stake.

Would Be Devastating

Among the thrusts of the government’s probe, sources say, is to determine whether Milken helped some Drexel clients pursue merger targets by encouraging others, such as Boesky, to help gather and manipulate the targets’ stock. Also in question is whether Milken and the firm illicitly profited from such activities. Such activities could lead to criminal charges against Milken, some of his colleagues and the firm itself.

Any finding that Milken was at the center of a pattern of wrongdoing would be a devastating blow to Drexel and to some of its top executives, especially Frederick H. Joseph, the firm’s chief executive, who has risen to the firm’s executive suite partially on the strength of his identification with Milken.

Milken’s development of the active new-issue junk bond market has been so central to Drexel’s rise to prominence among Wall Street investment banks, furthermore, that the firm will find it difficult to distance itself from Milken even if prosecutors bring a strong case against him.

“To a degree, what’s made Drexel Burnham has been Mike,” acknowledged one highly placed executive at the firm. “If you were going to build the perfect investment banker, from brainpower to sales ability, it would be him.”

Morale Fluctuated

Drexel employees say morale within the firm has fluctuated between the extremes of deep gloom and relief, depending on perceptions of how vulnerable the firm is to the investigations.

Drexel suffered through two particularly dark periods in 1986.

The first began in May, when one of its leading mergers specialists, Dennis B. Levine, was charged with having made $12 million in illegal inside trades during his employment at three firms, Drexel being the latest of them. Around the same time, the firm was embarrassed by the disclosure that one of its brightest new stars, Antonio Gebauer, was accused of having embezzled millions of dollars from his clients at his former place of employment, Morgan Guaranty Trust Co. (Gebauer later pleaded guilty.)

But that was nothing compared to the storm that broke Nov. 14, when the SEC announced that it had extracted $100 million in fines and penalties from Boesky to settle insider trading charges.

Boesky, it developed, had participated in the trading ring with Levine, who implicated him. Boesky was a top Drexel client as well.

The day of the Boesky disclosure, federal authorities papered Drexel and other firms with subpoenas; within days, it appeared that Milken was one of the probe’s targets, if not the principal one.

For months after that, many people on Wall Street assumed that the government’s entire investigation was aimed at Drexel. One break in the clouds appeared to come in mid-February, when federal agents made colorful and highly publicized arrests of three alleged insider traders linked indirectly with Boesky but employed by the investment firms of Kidder, Peabody and Goldman, Sachs.

Although the traders say they will fight the cases--making them the only formal targets of the Boesky investigation to put up a vigorous defense so far--and while the government’s indictment of the three makes its case appear exceedingly weak, Drexel people took heart from the indication that the probe had significantly widened beyond their firm.

“As times passes, we all feel better, because this is clearly not just a Drexel Burnham event,” says Joseph, hastening to add that, regardless of the firm’s relative exposure, “it’s terrible for the industry. . . . You can’t be in the securities business if people can’t trust your integrity.”

Still, the identification of Drexel as a major focus of the federal probe has created myriad problems for the firm. One is its exposure to civil lawsuits from companies and people contending that they were injured by Boesky’s machinations and Drexel’s complicity. Emblematic of those is a suit filed in February by Staley Continental, a Chicago food-processing and food-service firm that claimed it was forced to withdraw an important common stock offering in November, 1986, because Drexel interfered with the issue.

Staley took care to place its claims against Drexel against the backdrop of the government’s earlier, unrelated, allegations against the firm, particularly those derived from the Levine case. It also drew heavily from other unrelated civil suits against the firm.

Proposed Buyout

Staley’s own contentions lent new color to what Wall Street had always described, if disingenuously, as Drexel’s unusual aggressiveness. According to its complaint, two Drexel executives began calling Staley executives in the weeks before the scheduled stock offering, noting that Drexel had accumulated a large position in Staley stock and soliciting the company’s investment banking business.

Drexel urged Staley to consider a leveraged buyout in which the company would be taken private, the suit says. Learning that Staley intended to proceed with its offering, one of the Drexel people allegedly said: “It is very important for us to sit down and talk before you do something that hurts me and I do something that hurts you.”

Staley claimed its stock offering failed because Drexel, rebuffed, used its hoard of stock to depress the market for Staley’s shares.

Drexel responded that Staley had placed an incorrect interpretation on the Drexel executives’ words, that in proposing a leveraged buyout they were suggesting nothing illegal 099, most important, that Drexel did not sell any Staley stock during the period of the stock offering--meaning that Staley’s key allegation was wrong. Drexel also noted that the November stock issue was the second one Staley was forced to withdraw in 1986 because of market disinterest.

The flood of negative publicity has also posed recruiting problems for Drexel, according to Wall Street headhunters.

“Most of the headhunters I know are working against them,” says Richard Zander, a leading Los Angeles-based recruiter of retail securities brokers. “Everybody’s waiting for the other shoe to drop; the problem is that nobody knows if the firm is going to be able to withstand what’s ahead.”

On the other hand, Drexel has not lost a significant number of key employees during the crisis. Most brokers who have left, Zander says, were members of transient groups who customarily move to a firm en masse , strike a deal for exceptional compensation over a finite period and move again after their contracts expire.

Reluctant to Hire

On the retail side, Drexel’s allure for ambitious brokers is obvious. “Why would you leave a firm that was so creative, gives you the product you need to make sales and allows you to do things you can’t at a more restrictive environment, like Merrill Lynch or E. F. Hutton?” Zander asked. But one factor keeping important employees at Drexel--particularly in investment banking departments--may be the reluctance of other firms to hire them until the scope of the federal investigation is clearer.

“At this point,” said an executive of a rival firm, “you have to treat them as radioactive material.”

The crisis at Drexel has inspired many of its competitors to try to seize an advantage in other ways. Drexel executives say their clients have been getting frequent calls from rival firms suggesting that Drexel would fail, spreading rumors about the direction of the federal investigation. Firms such as Goldman, Sachs and Salomon Bros. were among those trying to lure clients away.

“A lot of our clients even let us listen in on some of those calls,” one Drexel investment banking executive said. “Most of those firms have probably put five times as many investment bankers into contact with our clients in the last few months as before. Their results so far have been pathetic.”

“Other firms thought they saw an opportunity, because of the pressure, to step up the competition,” Joseph said. “Some firms really took the low road, telling our clients that Drexel would not be able to do their deal. That was aggravating--and gratifying that it didn’t hurt us. Some of these firms lost ground in the eyes of some of our clients by acting in ways that weren’t nice.”

Rivals Landed Jobs

“We’re all in contact and making pitches,” said an executive of one rival firm. By most Wall Street accounts, the most aggressive would-be raiders of Drexel rivals are Morgan Stanley, First Boston, and Shearson Lehman Bros..

Yet there have been few unalloyed successes. That is not to say that Drexel has had a stranglehold on deals in areas where it has traditionally dominated, for rival firms have scored some impressive transactions. Early this year, for example, First Boston underwrote a $1.1-billion junk bond issue in connection with Campeau Corp.’s takeover of Allied Stores, the largest such issue of the quarter.

Campeau, however, was not a former client of Drexel’s, and, in any event, the deal was largely made by First Boston’s willingness to commit a generous share of its own capital to Campeau as a “bridge loan”--an increasingly familiar maneuver through which many investment bankers have won deals.

Perhaps more important was the decision of Kohlberg Kravis Roberts, the leveraged buyout firm, to turn to Morgan Stanley for help in financing its acquisition of Owens-Illinois earlier this year.

KKR was historically a Drexel client, a relationship that contributed to a sense on Wall Street that the Owens financing was “very significant,” in the words of one Drexel competitor.

Joseph disputes that, contending that KKR “has always done business with other firms. We will be doing a lot more business with them.”

Drexel competitors also note that the firm has been involved in no hostile takeover bid since the end of last year. Drexel executives acknowledge that they have become more cautious about such high-profile and speculative transactions.

“Hostile takeovers are deals we always looked at very carefully,” said John Kissick, Drexel’s executive vice president and director of West Coast corporate finance activities. “They’re so emotionally laden that we’re more conservative now, if anything.”

Merger professionals say that Drexel still has some notable advantages over its competitors when it comes to backing aggressive entrepreneurs and junk bond-grade companies. “I don’t think Shearson, First Boston or Morgan Stanley have the same self-confidence in being entrepreneurs and rolling the dice and backing such start-ups,” one said.

Another, noting that trading ability is a keystone to maintaining a strong position in underwriting a given category of securities, acknowledges that Drexel’s domination of the secondary market in junk bonds, based on the knowledge and skill of Milken and his trading group headquartered in Beverly Hills, gives it an unmatched advantage in attracting and keeping junk bond business.

Image Problems

Despite the firm’s image problems, a good portion of that business comes from new clients. Of the 15 junk bond issues, valued at a total of $3.35 billion, that Drexel underwrote in the first quarter, Kissick said a third came from first-time clients. The figure for the second quarter, he says, may be higher, as much as 40% to 50%.

Yet, as time passes, Drexel’s grip on this market will almost inevitably weaken. One development challenging Drexel’s important role in financing mergers--whether hostile or friendly--has been the willingness of other major investment banks to commit their own capital resources to clients planning to finance deals.

These commitments, known as bridge loans because they span the period between the closing of a deal and the point that bonds can be issued to cover long-term financing needs, have been critical in enabling some firms to win roles in important transactions. A capital commitment, among other things, assures a target company that its bidder will be able to complete a deal.

As such, the bridge loans have become key weapons for firms to use against Drexel’s famous “highly confident” letters: written commitments in which Drexel assured parties to a transaction that it would be able to raise money in the junk bond market for the deal.

“Committing your own capital is the best ‘highly confident’ letter,” said an investment banker at a competing firm.

Drexel’s Joseph says the firm is fighting the bridge loan arsenal with bridge loans of its own: “When it was developed, it was an effective technique for dealing with us,” he said. “But we are prepared to do them, and we’ve already done a batch.”

Meanwhile, Drexel may find it difficult to keep clients who aspire to the cachet that more elegant investment banking firms can lend them. Said the top executive of one former Drexel client who took his corporate finance business to Morgan Stanley: “Morgan takes me on the road and introduces me to 150 of its best customers. I’m a junk bond credit now, but one day my company will be investment grade. And when that happens, I want those customers to know me and remember me.”

For now, there is little doubt that the greatest threat to Drexel’s future comes from the SEC and Justice Department investigations. Joseph argues that, so far, the firm’s complicity in wrongdoing has not been proven by even the crimes admitted to by former employees. “We have 10,300 employees, and--what, three crooks?--at our firm.” But he acknowledged: “We must have a zero accident rate. We must be fail-safe.”