December 17, 2010
By Mikhail Overchenko, Vedomosti
It would be hard to find an example of an entire economic sector whose creation was closely connected with the name of a single person. Yet this is precisely the case with the speculative-grade junk bond market, which was created by Michael Milken.
During the 1970s and 1980s, Michael Milken provided thousands of small businesses with mass access to U.S. capital markets. These companies didn’t have high credit ratings, and as a result they didn’t attract major investors’ attention. Thanks to Mr. Milken, the investment company Drexel Burnham Lambert became the leader in the speculative-grade bond market. On the other hand, at that time Mr. Milken was called a “predator” and one of the craftiest con artists in the U.S. (see insert). In 1989, the U.S. government accused him of breaking securities laws and demanded that he disclose information. After confessing to several violations, Mr. Milken agreed to $200 million in fines and one year and 10 months behind bars. Furthermore, the court forbade him from working on the securities market.
But Mr. Milken isn’t idling away his time. Since the early 1970s, he has been involved with financing and organizing the mobilization of funds for medical research in the fight against cancer, melanoma, leukemia and other serious illnesses. “Mr. Milken’s activity has increased popular knowledge about cancerous diseases and saved many lives,” said Andrew von Eschenbach, Commissioner of the United States Food and Drug Administration, one year ago. Mr. Milken recently visited Moscow to participate in The Russia Forum, organized by Troika Dialog. During his visit, Mr. Milken sat down for an interview with Vedomosti in which he spoke about supporting stable economical development through promoting national health.
– You have been called the creator of the junk bonds market. How did you come up with this idea?
– The main question was how small and medium-sized companies can attract capital. After all, these companies create the most jobs. On the other hand, companies with high credit ratings create fewer jobs. There are very few companies in the U.S. with high credit ratings. As of today, for every company in the U.S with a high credit rating, there are 10,000 companies lacking such a rating.
The history of credit markets shows that corporate debt is the best form of debt, while sovereign debt and individual debt are some of the worst. The premium on loans to small and mid-sized companies – businesses of the future, growing businesses – was too high, while the actual risk wasn’t that high. The idea was to provide access to capital for such companies – future leaders who had new ideas. Investors also received a higher return on their investments; and these companies have justified high yield for centuries, not just in recent time. Therefore, the time had come to establish an actual market that would allow thousands of institutional and private investors to transfer funds to entrepreneurs capable of creating high yield. Russia, like many other countries, faces the same problem now. Today’s small and medium companies are the major companies of tomorrow. Today’s new idea is tomorrow’s large business. Thirty years ago, cell phones were just a new idea that seemed very risky. It took considerable effort to secure capital for those who realized this technology.
– How can investors determine how promising a company, its ideas and business are?
– First of all, you need to understand who its leaders are. Great companies with bad management make for bad companies. Companies with excellent management often become great companies. So first I look at the people. In the case of cellular telephones, one of the founders was a man named Craig Mackey. He had a vision, and he built the future. Vision in combination with the desire to implement the idea and the ability to do so – this is very important.
So first you need to understand the company”s managers and the market on which the company operates. Second, you have to understand how the market is changing. One of the most significant changes in the world in the last 20-30 years is the transition to digital information storage. The lowering of the cost of storing and processing data has enabled goods, information and people to easily relocate to anywhere in the world and revolutionized many industries, including medicine and education. And those who were closely tied into traditional media (newspapers, etc.) are now in a very difficult position.
– How is raising capital for traditional companies different from raising capital for new companies, startups, and research organizations?
– For well-established companies with high credit ratings, the value added by attracting capital is insignificant. They receive loans under interest rates slightly higher than rates on government bonds, and they pretty much always have access to capital markets. But the greatest added value can be obtained by finding a way to finance companies that are not included in this category. In my view, there is a greater impact in this case, as you are contributing to the development of new industries, supporting entrepreneurs and helping small companies to become the largest companies in the world and create jobs – in Russia, China, India, Brazil, and the United States. All governments should be thinking about how to create jobs for their citizens. Many countries depend on companies in aging and declining industries. General Motors, one of the world’s largest companies for most of the second half of the twentieth century, went bankrupt last year. Hundreds of thousands of people work there. But its cost structure, benefits programs, and product line became obsolete. It was a quick bankruptcy in which the U.S. government provided capital to General Motors, but the company needed new management and a new strategy.
The conclusion I reached after 40 years of working as a financier and studying the economic history of the past 200 years lies in the fact that such companies representing antiquated industries are often fraught with more risk than people think. And the risks involved with companies of the future are often lower than it seems.
– What strategy should be followed by startups and R&D organizations wishing to attract capital? What do they need to demonstrate to potential investors?
– Each company has its own criteria. I myself first look at whether there is a need for this particular product or service and whether they address societal problems. Individual productivity is society’s greatest asset. How can the product or service which the organization offers increase human capital?
Other than relying upon natural resources, which eventually run out, how else can you increase the main asset of any country – the productivity of its people? Is it through business, which can increase the level of education and skills, and making people more productive? Does your business help improve their quality of life and health care standards? Russia faces numerous problems – for example, lower life expectancy, especially among men. How can you make people healthier, more productive, and extend their lives? Few people realize that 50% of economic growth over the past 200 years was ultimately provided by improvements in the quality of medical care.
– I once read that the construction of sewage systems saved more lives than all drugs put together.
– The government can receive its greatest returns through improvements to sanitary conditions – providing clean water, etc. In the year 1900, average life expectancy across the world was only 31 years; it had increased by just five years over the previous century. By the end of the twentieth century it had increased to 66 years old. The doubling of life expectancy had an enormous impact on economic growth and the transfer of information from one generation to the next.
Another factor that people underestimate is the quality of education. The Russian population is highly educated and its literacy rate is one of the highest in the world. As Anatoly Chubais (Head of Rosnano and a speaker at Troika Dialog’s The Russia Forum) remarked, the world has a great appreciation for Russian poets, dancers, musicians, and composers, but not for Russian entrepreneurs. You need to raise the entrepreneurs. It may take a decade for the kind of entrepreneurs to appear who can create and provide new technologies. The issue is not only to ensure they have access to capital. We need to raise the people who are brave enough to take on the realization of new ideas.
– What is the best way to develop human capital? What is the role of the government and the private sector in this?
– The U.S. Government has financed innovations for years and years. The strongest factor in this area during the XXth century was the satellite. The USSR launched the first satellite into space in 1957. This was a glorious day for the USSR. But the U.S. derived the greatest benefit from this event, as the government began to allocate funds and established the Defense Advanced Research Projects Agency (DARPA) followed by the National Aeronautic and Space Administration (NASA). The internet was originally built upon the technology used by the DARPA. A considerable amount of research and development is the result of NASA work. Therefore, the innovations were at first financed by the government. Nowadays, this is the work of private entrepreneurs, while the government focuses on fundamental research. The private sector provides roughly 60% of investments into research and development, while the government – 40%.
Russia needs not only government support of research and innovation, but also the support of entrepreneurs. What can we think up to satisfy people’s needs? India is the perfect example. The people there cannot afford $10,000-20,000 for a vehicle. So they had to think up from scratch how to build a car that would sell for $2000-3000.
Several years ago, the Milken Institute prepared a report which assessed the ability of different countries to parlay research results into commercial products. One of the achievements of the United States and other countries is precisely the ability to create products on the basis of such research that people will buy. Russia has successful research centers; they need successful business centers.
– But there has to be an infrastructure allowing the inventors to deliver their products to the market.
– The U.S. government has never assisted in bringing products to the market. If we’re talking about the pharmaceutical and biotechnology industries, some of the best Alzheimer”s research to date was performed in Russia. These ideas are now being implementing by several companies in the U.S. and other countries. In my view, medicinal research is one of the most promising areas in Russia. At our conferences, we try to bring together officials, academics, representatives of charitable organizations, corporate executives and financiers. Together, such people can agree how to put these ideas into practice. In Russia, I would suggest that universities think over practical applications for their research and how this helps to address societal problems.
– Should universities be looking for companies and entrepreneurs who could turn their research into products?
– There are unique incubators in many of the world”s leading universities where professors and entrepreneurs discuss the possibility of joint action. Many small companies are created near such universities. University of California at Berkeley and Stanford University research in biology and physics has revolutionized these fields in the U.S. It’s no surprise that the headquarters of companies such as Intel, Sisco Systems, Oracle, Apple, Google, Biogen, and Genentech are located nearby. We could say that all of these companies emerged from these universities as a result of combining scientific research with entrepreneurs and local financiers.
– What is your opinion regarding nanotechnologies?
– This is a very interesting area. I think that nanotechnologies will impact lots of medical research.
– What is your opinion regarding financial innovations and the occasional abuse they engender? Is this inevitable?
– No. If we’re speaking about distressed mortgage bonds, which provoked the financial crisis, the creation of a security based on an asset that has no value does not create any value. And the new packaging does not change the facts. In some countries, particularly in the United States, it is believed that any loan secured against real estate is a good loan. They were founded in the belief that housing prices are always rising. Do a little research, however, and you will see that over the past 120 years prices fell for 50 years and grew for 70 years. So the idea at the root of these instruments was flawed, rather than the instruments themselves.
Speaking of the other sectors of the market, I would like to say that the problem is not in financial instruments as such, but in their misuse. You should look at the capital structure of the company receiving financing. Companies which manufacturer consumer goods have low business risks and stable income, meaning they can afford more debt, whereas companies with high business risks should have little debt or none at all. The idea that technological, agricultural and consumer companies can use the same methods of funding is wrong. You will not use a lawnmower to shave.
Many governments have undertaken commitments of medical care and social welfare that today are proving difficult to carry out. These commitments were made when life expectancy was much lower and people worked right up until their death. Today, with life expectancy in many countries reaching 80-90 years of age, it is very difficult to have people reaching 60 years of age and then retiring. When we speak about building society or opening access to capital, the first thing I think about is human capital – the most important element. Next is social capital – education, health, the state management system. Then you need access to financial capital. There is about $30 trillion of capital in the world looking for an investment target and promising entrepreneurs. And financial institutions should serve as the conductor of this capital.
How much money does Mr. Milken have?
According to a Forbes magazine report in 2009, Mr. Milken’s fortune totaled $2 billion. He doesn’t rule out that some of this capital could become available in Russia: “We are particularly interested in the opportunity to invest in my favorite areas – medical research and education. During my visit to Moscow, I met with representatives of these sectors to try and figure out what possibilities are available here.”