MERCHANT BANKING IS WALL STREET’S NEW CONSUMING PASSION : LUCRATIVE, GLAMOROUS--AND, ACCORDING TO SOME, THE RISKIEST INVESTMENT TREND IN YEARS

Wall Street’s fabulous new money-making gambit has one of its greatest fans--and one of its most aggressive practitioners--in Barry Friedberg. But Friedberg sometimes can strike an ominous note when he talks about it.

“A mistake by anyone can hurt everyone, and I assure you there will be a deal failure at some point,” the Merrill Lynch senior vice president said. The risks “have gone up tremendously” this year.

Friedberg’s prediction concerns the financial world’s latest passion: Instead of raising money from other investors, Wall Street firms are laying their own money on the line to consummate multibillion-dollar business deals--a practice called merchant banking.

So far, there have been no big disasters, in part because the investment firms’ most senior managers personally review the loans. But no one familiar with the merchant banking phenomenon would accuse Friedberg of being an alarmist.

It used to be that only commercial banks could lend their own money for business deals, and they were regulated closely because of the enormous risks. Now investment banks, which once limited themselves to raising money for others with stock or bond issues, are getting into the act.

And they’re going even further, frequently taking an ownership position in companies targeted for acquisition. Profits in the $50-million to $100-million range for a single deal are not uncommon.

“Our source of concern is that when an investment bank goes into merchant banking, it takes a step toward acquiring a type of vulnerability that commercial banks have,” said Jack M. Guttentag, a professor of finance at the Wharton School in Philadelphia. “The difference is, we have created an elaborate system of safety nets for commercial banks.”

Not since the Glass-Steagall Act of 1933 carved out separate roles for investment bankers and commercial banks and established the policy of federal insurance for bank deposits has one event so revolutionized this country’s money-lending business as has the onset of merchant banking.

Trying to curb the money-lending excesses of the 1920s, Glass-Steagall gave commercial banks the power to lend money and gave investment banks the securities and advisory business. Ever since, the two kinds of financial institutions have sought to get into each other’s business.

In merchant banking, they have essentially found a way to redefine their roles.

The most popular money-lending game in America borrows its name from Britain’s merchant banks, which got their start centuries ago by catering to the financial needs of European merchants. But, other than sharing a name, the two are not similar. What Americans call investment banks are called merchant banks in Europe.

As it is being practiced today in the United States, merchant banking is essentially a two-pronged business. When time and lots of cash are of the essence in a financial transaction, the players either put up their own funds in the form of bridge loans--so-called because they span the time between a deal’s closing and the arrangement of long-term financing--or they take equity positions in the deal. Increasingly, they are doing both. And both make some independent observers and even some traditional investment bankers uneasy.

One problem is the potential conflict of interest: How can an investment bank offer impartial advice to a client if it participates in a deal as the client’s partner? Another problem is the risk: Investment banks are putting an enormous amount of money--a huge percentage of their capital--into deals that may be overpriced and could go sour if the stock market or the economy starts to sink.

Potential for Conflict

Perhaps the most controversial merchant banking maneuver so far was Anglo-French financier Sir James Goldsmith’s unsuccessful hostile effort last year to take over Goodyear Tire & Rubber. Goldsmith led the raid but Merrill Lynch committed $2 billion of its own capital to the deal.

Robert Mercer, Goodyear’s chief executive, is outspoken about the potential conflicts.

“To call what they do taking an equity position is really just a euphemism for exploitation of a flaw in the free-enterprise system,” Mercer said. “It is obscene and it should be stopped.”

Speaking of the merchant banking phenomenon in general, Felix Rohatyn, the well-known investment banker, observed: “There is really (a) potential for conflict here. If you’re advising a client on a $3-billion deal and at the same time you see a chance to become a principal in the deal and get 20 times the (traditional advisory) fees, whose interests are you going to think about most?

“I say if you need to commit capital to your advisory business, maybe you ought to improve your advisory business,” Rohatyn said.

Others say they are becoming increasingly scared that some firm will make a misjudgment or mistake and trigger a series of investment bank failures. Misjudging the time needed to raise financing, overvaluing the assets that eventually must be sold off to repay a bridge loan or tying up too much of a firm’s capital in the rush to clinch a deal are mistakes that Wall Street fully expects to see happen.

Ernest Bloch, a New York University finance professor, paints this scenario.

“Suppose you didn’t do a very good credit analysis and you overpriced the deal; and then suppose that sometime during the financing, junk bonds come under attack and the financing is delayed.

“Maybe you were expecting a 60% return, figuring you would get your money back in a month. That’s an incredible return, but every month that goes by you get closer and closer to taking a big hit. And don’t forget that all this time you have your money tied up and you can’t do any other deals.”

Just as $1-billion deals are no longer uncommon, so too it is not unusual for these firms to have as much as one-half of their capital tied up in a single merchant banking deal.

“If something happens to raise the question of a borrower’s solvency, then these firms are sitting on loans whose ultimate value is unclear and a large part of their capital is tied up in it,” Wharton’s Guttentag said. “Are they solvent or aren’t they? None of us know whether the Fed would step in and help or not.”

The most spectacular--and riskiest--example of aggressive merchant banking to date was First Boston’s agreement last year to reach into its coffers for as much as $1.8 billion to clinch a takeover of Allied Stores by the Canadian company Campeau, which First Boston was advising in the deal.

The risk was high but First Boston fully recovered all $865 million it actually put into the deal last March after completing a debt offering. Citibank rushed in with the other half in an 11th-hour change of heart.

Campeau acquired Allied after a bitter and drawn-out battle with white knight bidder Edward J. DeBartolo. The deal made headlines because of the huge financial commitment agreed to by First Boston.

Although First Boston insists that its money was never in danger and defends the ultimate price of the deal, others intimately familiar with the transaction say First Boston came dangerously close to having the first merchant banking failure on its hands.

“There was a period when First Boston was really on the hooks,” one strategist who worked on the deal said. “It’s not that they didn’t do their homework. They did. But this was a new step in the direction of merchant banking: The huge size of the thing, the fact that it kept growing, the fact that it was drawn out longer than most of these deals are--and I think they just got caught up in getting this done at any cost, just to prove a point.

Some Deals Too Risky

“And you have to remember that everything worked fine. But I can assure you, it could just as easily have not worked fine. There was almost no cushion.”

Other investment firms are not so adventurous. One recently turned down a chance to participate in a deal that later earned a larger firm tens of millions of dollars. “It was just too risky for us,” a merchant banking specialist at the smaller firm said.

“The way some people are stretching for the smallest participation in this business,” he added, “you’d think they have to have these profits to cover their expenses. Hell, maybe they do.”

And critics of this sexy new business, which has lured virtually every investment banking house and most of the major insurance companies and commercial banks, argue that the stock market’s irrepressible climb and the economy’s unexpected resiliency are all that separate some overpriced deals from failure and some overly aggressive firms from insolvency.

As long as the markets have continued marching into ever-higher territory, the investment banks have had no trouble raising the money to pay off the bridge loans. Even deals that have looked marginal to investors have been oversubscribed because the value of their investments is guaranteed to grow as long as the market keeps gaining ground.

But overpriced deals would not be so warmly received during a bear market.

A sharp upward turn in interest rates could be even worse for merchant banking. Bond prices would drop sharply and the market for the bonds that investment bankers try to sell to raise money to pay off the bridge loans could collapse. Trading in junk bonds dried up for a while last November, for example, after speculator Ivan F. Boesky was indicted for insider trading.

Whispers of Overpricing

If investment banks run into trouble getting the huge bridge loans off their books or if the loans themselves go sour, the resulting strain on their balance sheets could impair all of their other businesses.

“A couple of the biggest deals just flat lucked out on interest rates because their valuations looked to be too high at the time and they’ve proved to be too high,” said a high-level executive at a competing investment bank that has been accused of undue caution. Had either deal failed, the financial firms would have survived but both would have taken huge losses.

It is widely whispered on Wall Street that three recent merchant banking deals were seriously overpriced--that is, that the cash flow from the companies involved would not even cover the annual cost of interest on the proposed deals. All three were bailed out, sources say, by luck: Interest rates stayed lower than expected and stock prices kept rising.

The three were the agreement in May by the investment banking firm of Morgan Stanley to fork over $917 million of its money to facilitate a leveraged buyout of Burlington Industries, Merrill Lynch’s agreement last year to lend $375 million for the leveraged buyout of Detroit truck and trailer maker Fruehauf and First Boston’s participation in the Campeau takeover of Allied.

Although the latter was a success, the jury is still out on the Burlington and Fruehauf deals, because the long-term financing has not yet been completed. Hence, the bridge loans made by the investment firms have not yet been paid off, meaning that the firms’ capital is still tied up.

The risks can only worsen, Rohatyn predicts, as the field gets more crowded, as firms squeezed by skyrocketing expenses increase their reliance on fabulous merchant banking profits and as the stock market wanes.

“We’ve all been spoiled by the market’s run-up,” said Rohatyn, whose firm, Lazard Freres, has shied away from merchant banking because of troubling questions it raises about capital adequacy and potential conflicts of interest with clients. What happens, he asks, “when the market turns the other way and these firms don’t have adequate long-term capital” to cover a sour deal?

A parade of regulators, credit raters, corporate executives and business professors has started demanding answers to the same question.

Concerned that the level of risk had risen unacceptably high, thanks to the merchant banking business, bond raters at Moody’s and Standard & Poor’s recently undertook separate rating reviews of several firms with merchant banking divisions. In part because of concerns raised during those reviews about the adequacy of capital to cover these multimillion-dollar deals and the controls to oversee such transactions, both raters downgraded slightly their ratings of Merrill Lynch.

Merrill, the nation’s largest securities firm, is also widely perceived as the biggest and most aggressive player in merchant banking. “This is more credit risk than these firms have ever taken on before,” said Clifford Griep, a senior vice president at Standard & Poor’s. “If one of these transactions goes bad, even the biggest of these firms would take a very sizable hit and the possible exposure to insolvency is the primary cause for our concern.”

Both the Securities and Exchange Commission and the Federal Reserve Board also have been making inquiries into the adequacy of capital maintained by firms making merchant banking deals, according to several firms that have been approached by the agencies.

At the SEC, no “full-blown study” has been launched, said acting Chief Economist Annette Poulson, but “it is something we are very aware of and are trying to keep tabs on.”

The merchant bankers, not surprisingly, consider the criticism to be misguided.

“Let’s understand, this is a risk business,” said William Mayer, managing director of First Boston. “We get paid to manage risk.”

No Merchant Banking at Drexel

And to suggest that the firms would cave in to potential conflicts for a few million dollars, Mayer believes, “is almost an insult to the client; you couldn’t possibly get away with taking advantage of people that way.”

He and others, in fact, make the argument that corporate clients are better served than ever before because now that their advisers have their own money on the line, their advice carries more weight.

Staley Continental, an Illinois corn-processing and food-service company, takes strong exception to that viewpoint. Last February, Staley sued its former investment banking adviser, Drexel Burnham Lambert, for allegedly trying to pressure Staley into a leveraged buyout that would have added millions of dollars to Drexel’s coffers.

When Staley insisted on a different strategy, the lawsuit alleges, Drexel tried to sabotage the resulting stock offering by dumping Staley shares.

Drexel denies the charges and the case is still in its early stages. But it is being watched closely by those troubled by potential for conflict of interest in merchant banking deals.

Drexel, while making a few bridge loans of its own, has not taken an active role in merchant banking so far. In fact, many on Wall Street believe that merchant banking was devised for a very specific purpose: to one-up Drexel’s by-now-famous “highly confident” letters. In such letters, the firm tells clients, particularly corporate suitors in need of large sums quickly, that Drexel is “highly confident” that it can raise the money needed for a deal.

By 1985, Drexel had a firm lock on the market in high-yield (junk) bonds. And despite their best efforts, Drexel’s competitors simply could not crack the market.

Their solution: offer clients cash, not just “high confidence.”

Drexel and other firms are still writing “highly confident” letters for some transactions but, clearly, bridge loans have cut into the business because cash carries more weight than a promise to get the cash.

If Drexel feels stung by its rivals’ one-upmanship, it may yet find a way to have the last laugh.

The merchant bankers are already looking beyond the tools currently employed to even more daring ones. And Drexel’s name is often mentioned as one firm believed to be hard at work on the next generation of merchant banking deals.

Drexel isn’t saying. But no one on Wall Street would be surprised if one day the king of junk bonds announces that it is buying companies outright and either actively managing them or selling off the pieces.

Already some firms are joining with other equity partners to buy the companies that emerge from leveraged buyouts. In this way, Wall Street investment firms now own minority positions in untold thousands of U.S. companies--just as other firms specializing in LBOs do.

And Shearson Lehman Bros., for one, has structured several deals so that if a client cannot find a buyer for a property, Shearson will buy the asset itself.

But few merchant bankers go into these deals with a view toward long-term ownership and, so far, they have never gotten involved in managing the companies in which they hold minority stakes.

Both Criticized and Cheered

Perhaps Shearson has come closest to carrying merchant banking to what many consider to be the next logical step. In what is often cited as one of the most innovative merchant banking deals, Shearson last October effectively bought Sun Distributors, refinanced the acquisition by raising about $100 million of debt and then restructured the company and sold master limited partnerships in it. Together, Shearson and Sun’s management own a 50% interest in the company’s operations.

If Shearson, Merrill, and First Boston seem to be both criticized and cheered more than other merchant banking players, it is because they collectively do the lion’s share of the business. The big commercial banks--Citibank, Chase, Chemical, Security Pacific and Banker’s Trust--are vigorously scrambling alongside virtually every investment bank for a slice of this lucrative business, but Shearson, Merrill and First Boston, by some estimates, haul in as much as two-thirds of the business. And each firm estimates that it turns away at least five deals for every one it accepts.

Those estimates lend strong support to predictions in several quarters that merchant banking will dump America’s mergers and acquisitions business into the laps of the three or four best-capitalized firms.

“You can’t play this game without a lot of capital,” Shearson Vice Chairman Peter Solomon argued. “Of the 36 deals of $1 billion or more in the last year, we have done a third of them and that is because we have so much capital we’ve been able to put tremendous pressure on everybody else.”

This domination of the investment banking market by a handful of titans continues a trend that began in 1975 with the abolition of fixed commissions. Those that survived the shakeout have been forced to scramble both for ever-more-generous sources of capital and for new sources of profits. The profits are needed to offset the skyrocketing expenses that result from wooing and paying to keep talented strategists on the payroll in highly competitive markets.

In this environment, the discovery that companies were willing to pay far more than their usual advisory fees to bankers willing to put their own cash on the table was a gold mine.

For its aid on the Campeau deal, for example, First Boston took home more than $100 million in profits--more than the entire annual earnings of many smaller investment firms.

But not even the promise of such startling winnings has been sufficient to lure some prominent investment firms into a business they consider too risky. After much study, Salomon Bros. has decided to dabble only cautiously in merchant banking and Goldman Sachs still has not taken the plunge.

WALL STREET’S BIGGEST BRIDGE LOANS Bridge loans are one of two activities that together make up Wall Street’s merchant banking craze. They are temporary financing for takeovers and leveraged buyouts (LBOs)--money that “bridges” the period between the closing of a deal and the time when bonds are issued to cover the long-term financing.

Bridge loan Investment Deal (in millions) bank Date of loan Harcourt Brace Jovanovich $985 First Boston July 23, 1987 recapitalization Union Carbide restructuring $976 First Boston Dec. 8, 1986 Morgan Stanley and $917 Morgan May 24, 1987 Burlington Industries Stanley management LBO of Burlington Campeau Corp. hostile $865 First Boston Oct. 31, 1986 takeover of Allied Stores Management LBO of Hospital $800 Drexel May 31, 1987 Corp. of America Burnham Management and Merrill $705 Merrill Lynch May 18, 1987 Lynch LBO of Borg-Warner

Source: First Boston