IN THE TT 1950s Thomas Boone Pickens worked as a geologist at Phillips, an oil company based in Bartlesville, Oklahoma. He hated it. His working day was regulated. His colleagues lacked ambition. He found waste and inefficiency disgusting. “At Phillips, I met the monster: Big Oil,” he wrote. Mr. Pickens left to form his own company, Mesa Petroleum. Impatient with his progress, he devised a daring plan. He would kill the monster by using Mesa to buy out bigger, mismanaged companies.
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Against all odds, Mesa’s first big bid for Hugoton, a much larger natural gas company, was successful in 1969. But Mr. Pickens, who died on September 11, is best known for the bold take-over bids he made. ‘he did in the 1980s, notably for his former employer, Phillips. These failed, but not before they had driven up targets’ stocks and made Mr. Pickens a small fortune.
The one that had the most lasting impact on American businesses was his fondness for the Gulf Oil Company. Gulf was one of the top six US oil companies in 1984; Mesa was a minnow by comparison. It was therefore a courageous gesture. But what sets it apart is that this is the first major attempt at a hostile takeover backed by junk bonds. Drexel Burnham Lambert, a pushy investment bank, provided the financial muscle; Mr. Pickens provided the know-how of the petroleum industry. Corporate finance would never be quite the same again.
Leveraged buyouts (LBOs) were not entirely new. In the 1960s, they were used as a way for small family businesses to sell to managers without the cost of a public listing. But by the early 1980s, the financial landscape was changing. Specialist buyout companies were growing in importance, including Kohlberg Kravis Roberts (KKR). Mergers were viewed more favorably by trustbusters. And debt financing was there. Michael Milken, Drexel’s king of junk-bonds, had cultivated a network of investors eager for new issues. He bragged about being able to raise $ 4 billion to $ 5 billion for the race from T. Boone to Gulf.
Ideas about corporate finance were also changing. Decades ago, Franco Modigliani and Merton Miller proposed that a company’s capital structure – its combination of equity and debt financing – should not affect its value. It is the cash flow of businesses that matters, not the nature of the claims on them. But the theory doesn’t work well in the real world, with its bankruptcy costs and tax-deductible interest payments. The ideal capital structure has come to be seen as a compromise between the penalty for having too much debt (bankruptcy) and the penalty for having too little (waiver of tax benefits). An article in 1976 by Michael Jensen and William Meckling stated that even this theory was incomplete. Debt, they argued, was a means used by shareholders to maintain the honesty of running a business. Bosses feel more pressure to cut costs and increase revenue if they are faced with a heavy interest burden each quarter.
The Good Debt Doctrine has appealed to a new breed of corporate raiders. Mr. Pickens dusted off the Hugoton plan. He was looking for a large, undervalued energy company, taking a significant stake in it, then looking to take control of it – or at least push management to improve returns. Gulf Oil met its criteria. Its bid failed, but a competing bid from Chevron, another oil giant, succeeded. Mesa made hundreds of millions of dollars on his stake. And Mr. Pickens’ race in Gulf has become the model for many successes. LBOs.
The legacy of the Mesa-Gulf offering is all around today. High yield (junk) bonds are no longer the shameful offspring of the fixed income family; they constitute an established asset class. The median credit score of an American company has fallen to BBB, a cut above the junk. In large part, this is because of the corporate finance strategy: many established companies have chosen to take on debt to increase shareholder returns. If a company refuses to “optimize” its balance sheet by taking on more debt, a group of capital-rich buyout firms stand ready to do the job.
Trends in finance tend to go too far before reversing. But we already have an idea of the forces that could potentially make debt financing less attractive. Tax reforms, in America and elsewhere, have sought to limit tax breaks on debt. Another catalyst is the changing nature of business. With the advent of the Internet of Things, large digital businesses must demonstrate that they are safe to stay in business for decades in order to persuade customers to sign up with them. Highly indebted companies will be seen as riskier counterparties. Who knows? Perhaps a future T. Boone Pickens will argue for a greater capital cushion as an essential part of an optimal capital structure.
This article appeared in the Finance & economics section of the print edition under the title “Rich Pickens”