Grieving Over Junk Bonds: Some Firms Sure Miss Them : Finance: Although high-yield debt came to symbolize excess in the ‘80s, many small and mid-sized companies relied on it for growth. Now, they face a credit crunch.

Michael Milken probably had companies like DEP Corp. in mind when he extolled the benefits of junk bonds for the American economy.

DEP, a Los Angeles-based maker of hair- and skin-care products, added a wing to its plant, created more than 100 new jobs and grew from a modest $18 million in annual sales to more than $100 million today. This was made possible by a financing in 1986 that included a $16.5-million high-yield bond offering by Drexel Burnham Lambert.

Now, Drexel is gone. The junk bond market remains depressed. And Robert Berglass, chairman and president of DEP, claims that his company and thousands like it are facing a credit squeeze that could ultimately hurt the national economy.

Despite DEP’s profitable performance, the company has found that it can no longer raise capital, at least not without giving up a major chunk of equity. As a result, DEP has had to scale back its growth plans dramatically, including scrapping a strategic acquisition that it had hoped to make earlier this year.

“Making a phone call and saying we need the money used to be the easy part,” Berglass says. Now, “It’s back to the ‘70s, when money was very hard to come by.”

While defaults on junk bond debt have led to highly publicized disasters, and junk bonds themselves have come to be synonymous with the excesses of the 1980s, the sudden absence of the junk bond market may also be placing a lid on the growth of medium-sized and smaller companies. Not only can’t companies resort to the junk market for capital, but the demise of the junk bond trade and spill-over from the savings and loan crisis is also having an impact on commercial banks, prompting them to significantly raise standards for granting commercial loans.

The head of the West Coast corporate finance office of a major Wall Street firm, who asked not to be identified, says the situation is dire for companies with less than $100 million in annual sales. “The unfortunate truth is that there is a horrendous squeeze right now,” he says.

The economic consequences of a true credit squeeze on smaller companies could be severe. In the 1980s, these firms played a major role in U.S. economic growth. In the past decade, as employment by Fortune 500 companies actually contracted, growth by smaller companies fueled the upsurge of private-sector job creation.

Economists caution that the true extent of a credit crisis is far from clear. Robert Dederick, chief economist for Northern Trust Co. in Chicago, says there is lots of anecdotal evidence. But he says there aren’t any hard statistics yet proving that companies actually are being starved of growth capital. The Federal Reserve is said to be looking into it. “Any quantitative numbers simply haven’t appeared yet,” he says.

The lack of hard numbers is small comfort to companies such as North American Watch, another former Drexel customer, which imports and wholesales wristwatches. The company, based in New York, had raised $70 million through two junk offerings in the 1980s. Now, according to Gedalio Grinberg, the chairman and chief executive, the company has had to drastically scale back plans for expansion and acquisitions. “The best thing to do is take a very conservative approach now,” Grinberg says. “We won’t even consider further acquisitions while this (junk bond) market is as it is.”

Many of the biggest junk bond offerings went to finance corporate raids that had little apparent economic benefit. But Milken and other proponents of junk bonds maintained that many offerings went directly to financing the growth of small entrepreneurial companies. Douglas Brengel, a senior corporate finance official in Salomon Bros.’ Los Angeles office, says the excesses of junk bonds--the kind of debt that led, for example, to the bankruptcy filings by Campeau Corp.’s retail units--deserve to be swept away. He says, however, “The casualties are the 50% of the market or more that are the kinds of companies you’re talking about--growth-oriented companies that use this market as an alternative to more costly and restrictive sources of funds.”

To be sure, there are plenty of small, entrepreneurial companies that raised money from junk and then promptly sank under the weight of the debt. Penril Corp., a small Maryland maker of data communications equipment, raised $18 million through a Drexel junk offering in the mid-1980s. Management went on a buying spree and the company ended up in default.

“Drexel told the people who were running the company then that money is available now; why don’t you take it all now and do your expansion at once,” says Henry David Epstein, who was brought in later as chairman and chief executive to turn around the company.

But now, the company has returned to financial health. And Epstein says he would like nothing better than to do a junk offering himself. He can’t because of the state of the junk market.

“Now that the company is healthy, I’m expansion minded,” he says, adding: “It would be great if I could issue some high-yield bonds to buy some things. But I can’t. There really is no high-yield bond market left for a small company.”

Na-Churs Inc., an Ohio-based maker of liquid fertilizers, has had its ups and downs since Drexel completed a $20-million junk bond offering for it in 1981. In the late 1980s, the company did a leveraged buyout, mainly with internally generated cash.

Now, according to company President John D. Kelly, Na-Churs is beginning to think about making an acquisition in 12 to 18 months. But he says the financing prospects are daunting. The company would have to give up a substantial amount of equity warrants to get the money it needs. Deals are being structured, he says, so that companies can buy back the warrants, regaining the ownership stake. But, he says, “In exchange for getting those warrants back you may be paying a very substantial sum.”

There is, of course, good old-fashioned internal growth--development of new product lines, steadily building market share over time. But company executives say, in today’s world, growth for smaller companies also rests on growth by acquisition, such as purchase of strategic product lines. In the current credit environment, executives at smaller companies say the giants have a distinct advantage.

DEP could raise money now, but only by agreeing to give up a big ownership stake to an investor. DEP’s stock is traded publicly, and Berglass maintains that diluting current stockholders’ ownership stake wouldn’t be fair.

Berglass says DEP and other small companies in the personal-care industry lately have had to sit back and watch while giant companies such as Colgate-Palmolive and Procter & Gamble use their huge financial resources to gobble up successful brand names.

For many companies, the situation at commercial banks is even more worrying than the state of the junk market itself. Most commercial banks have big exposure to loan losses from deals involving junk bond financing--deals now referred to in banking parlance as highly leveraged transactions, or HLTs.

Bank regulators, alarmed by the impact of junk bonds on the savings and loan industry, have begun pressuring commercial banks to separate out their HLT loans in financial reports and to monitor their lending practices more closely. As a result, many banks seem to have become much stricter about the kinds of commercial loans they will make, as well as the conditions they attach to them.

Frank Abraham, senior vice president and chief financial officer of Security Pacific’s Middle Market Bank, which lends to medium-sized companies, maintains that Security Pacific has always applied stringent standards to commercial loans and isn’t tightening up. But he says banks in general throughout the country seem to be raising their standards. And, significantly, he says fewer smaller banks and foreign institutions now are willing to take parts of syndicated loans. Such big syndicated loans, in which the actual lending is divided among a series of institutions, have been an important alternative to junk financing for smaller companies.

Banks are becoming stricter, too, because they are under pressure to boost their capital by the end of the year to meet new requirements.

For a small but not insignificant sector of industry, the specific impact of the demise of Drexel itself seems to be having a negative impact. Drexel’s parent company went into bankruptcy proceedings in February and has begun liquidating the company. When Milken and Drexel were building the junk bond market in the late 1970s, they invented the idea of creating new junk bonds to provide capital to smaller companies. Previously, junk bonds were all “fallen angels”--the bonds of previously investment-grade companies that had fallen on hard times. So Drexel became the investment banker to hundreds of companies in which no other Wall Street firm was interested.

Now, Wall Street firms are engaged in a feeding frenzy, courting the Drexel customers that were transformed by junk bonds into giants. But, for the most part, they’re not interested in today’s smaller companies, including some that had obtained financing relatively recently through Drexel. Brengel of Salomon Bros. says with a few exceptions, investment banks are unlikely to be interested in companies with $100 million or less in sales.

The general decline in the securities industry is also likely to have an impact. Because of falling profits at Wall Street firms, many are reducing the size of the corporate finance departments. And the type of deals that can get done now produce much slimmer commissions, making them less attractive.

In general, the only kinds of high-yield financings that can get done these days are private placements of debt in which the buyer of the debt securities--such as insurance companies or foreign banks--demand warrants or some other sort of equity stake. For investment banks, commissions on such private placements tend to be about 2% of the financing, as opposed to the 5% or 6% that was common on public offerings of junk bonds, providing less incentive for the Wall Street firms to do the deals. Although in the current environment investment banks probably will have to get used to doing smaller deals, executives at smaller companies say they don’t see signs of it yet.

Smaller West Coast companies may be at a particular disadvantage, since several Wall Street firms have announced plans to close or reduce the size of their West Coast offices.

Salomon has actually expanded its West Coast presence recently. But Brengel acknowledges that for smaller companies, for better or for worse, “a lot of the deals that did get done in the past just aren’t getting done now.”