Morgan Joseph

Morgan Joseph’s Sorte Waits for ‘More Shoes to Drop’ on Economy
4/14/09

April 14 (Bloomberg) -- John Sorte, who was chief executive officer of junk-bond king Drexel Burnham Lambert Inc. when the company went through bankruptcy, says he expects “a couple more shoes” to drop before the economy rebounds.

Now the CEO of New York-based investment banker Morgan Joseph & Co., Sorte says potential bankruptcies by General Motors Corp. and Chrysler LLC will affect many suppliers. A second shoe, Sorte said, is the insurance industry where it’s still not clear how much “asset destruction” has occurred.

“I’m not willing to tell my clients that I’m sure we’re at the bottom and they should buy assets at today’s prices,” Sorte said. “Those two shoes dropping are things I’m concerned about, but if they happen in such a way that they are manageable and the psychology of the rest of the market has improved, then we could in fact be at the bottom.”

Sorte, 61, has known tough times. In the 1980s, he was co- head of investment banking at Drexel Burnham and later managed the company through bankruptcy.

Drexel Burnham was made famous by Michael Milken, who popularized high-yield “junk bonds.” Milken, who eventually served 22 months in prison for securities violations, is now ranked 334 on Forbes magazine’s list of the world’s wealthiest people.

Morgan Joseph are the names of its chairman, John A. Morgan, a great-grandson of the financier J.P. Morgan, and managing director Fred Joseph, who was CEO of Drexel Burnham before Sorte.

Sorte’s grandfather was Major General Follett Bradley, a U.S. Army officer who flew in a Wright Brothers biplane and was sent by President Franklin Roosevelt to supply aircraft to the Soviet Union at a critical time during World War II. Sorte received a bachelor of arts degree from Rice University and a master’s in business administration from Harvard University.

Morgan Joseph recently joined the International Network of M&A Partners, or IMAP, a group of investment-banking firms that’s helping expand the firm’s work outside the U.S. Sorte was interviewed during a recent visit to Los Angeles for an IMAP conference.

Brennan: There is so much noise and confusion in the economy. In your opinion, what went wrong and what is occurring right now?

Sorte: That’s not a sound bite-type answer. We just had an hour-long presentation by David Smick, the author of “The World is Curved” at the IMAP conference. I think, to summarize what he said, the tip of the iceberg was the subprime mortgage situation, which basically caused people to focus on the over- leveraged society we were living in. It was exacerbated by derivatives and swaps and insurance against debt defaults and so forth.

It comes down to the fact that the world got way, way over- leveraged. The regulators, the management of a lot of these banks, didn’t realize that we had a huge debt bubble.

One of the things I like to quote was when I was at Drexel Burnham back in the 1980s and of course Michael Milken popularized high-yield bonds. In the mid-1980s, he started warning people that we were over-leveraged then.

Companies that had the foresight to de-leverage and put equity on their balance sheets did a lot better than those that didn’t. This is something that occurs every 20 to 30 years. We’re in another one of those cycles where we got way over- leveraged. This one, because of new technology and new debt instruments and new lending entities such as hedge funds, is the worst that most of us have seen in our lifetimes.

Brennan: Is there any one metric that you use to determine whether someone was over-leveraged?

Sorte: The financial institutions used to be leveraged 10- to-1. The big investment firms leveraged themselves 30-to-1. They were way more leveraged today than Drexel Burnham was 20 years ago when it went into bankruptcy.

Even more importantly to the economy as a whole is the fact that many corporations are over-leveraged compared to historical levels. Leveraged buyouts that historically would have four times their debt to Ebitda, financial institutions were lending seven, eight, nine times at the peak.

Brennan: Was this over-leveraging easy to spot?

Sorte: There were some people who were saying that. Oaktree’s Howard Marks, the commentator who I very much enjoy reading, was warning about this for several years, that we were in a bubble for debt.

People got greedy. They would say, “I know we’re getting over-leveraged, but as long as someone is willing to give me the money, I will take it and when the market turns, I’ll pay it down quickly.” That’s the same type of thinking that caused people to keep re-mortgaging their houses because their housing prices kept going up and they figured they could re-mortgage it one more time. When the music stopped, they were left holding an asset worth less than the mortgage.

Brennan: Where are you looking to make money going forward?

Sorte: Our business has historically been 50 percent mergers and acquisitions and 50 percent financing. Right now, the equity financing market is totally shut down. The debt market, there are signs that credit is coming back, that you can do a relatively expensive debt for middle-market companies. It’s slowly growing back. We’re not focusing on financing because it’s not that attractive for our clients. We’re focusing on three main things.

Restructuring. We hired a seven-person restructuring group that’s now grown to 10 people. We’re engaged by a number of companies and creditor groups to restructure both in and out of bankruptcy.

The second thing is cross-border transactions. We’re the newest member of IMAP. We have offices across the U.S., but our business is domestically focused, with some in China. We do not have a reach into Europe, Latin America, India, where there are real M&A activities.

There are some economies such as in Latin America where they have companies not nearly as over-leveraged as U.S. companies. They have been for years trying to figure how to get into the U.S. market. Today, these Latin American companies have identified subsidiaries or divisions of U.S. companies that are not core businesses. This is good time because a lot of U.S. companies are over-leveraged and could sell a non-core business. That transaction makes a lot of sense.

The other type of transaction is U.S. companies that have divisions in foreign countries. Europe, Latin America, where U.S. companies that are over-leveraged need to pay whatever assets they can to pay down debt. A division in Brazil might have been viewed as core two years ago today could be expendable because their very survival is at stake.

The third area is exchange offers including the 3(a)(9) where you don’t have to register with the SEC and you can exchange your existing debt for equity. That was a big business in the 1980s for Drexel.

Brennan: Several companies similar to yours are publicly traded. Are you thinking along the same lines?

Sorte: We were thinking along the same lines two years ago. We were in discussions with several banking firms who approached us. We A, missed the market, and B, are very glad we did. The companies that went public at $10 to $15 a share are trading for $1 or $2 a share and their ugly results are out there for everybody to see.

By the time we made the decision, the summer of 2007, we would have to do it based on year-end 2007 audited financials, it was no longer possible. Now we’re happy.

Our ultimate goal at Morgan Joseph is to be a public entity. We’re not planning to sell out to a larger financial institution. Most of our bankers have come from larger institutions. They specifically came to a firm like Morgan Joseph to work in a smaller more entrepreneurial environment where they have an ownership stake. We’ll just have to wait for the next cycle.

Brennan: What do you think is the legacy of Drexel Burnham now that it’s 20 years in the past?

Sorte: The legacy is that it made capital a lot more democratic. Drexel did not do the first high-yield bond. A lot of people think so but it was actually Lehman Brothers. Drexel popularized high-yield debt as a way to help growing companies compete against larger Fortune 500 companies. The companies who benefited from that were the MCIs and the Ted Turners. It’s now an instrument now sold by every investment bank in the world. It made it possible in the Western world for medium-size companies to grow rapidly.

Morgan Joseph has done a number of transactions in China, which doesn’t have anything like a high-yield market or Nasdaq. It’s very difficult for medium-size companies in China to get capital to grow. That’s what it was like in the United States before high-yield bonds and Nasdaq. There are so many companies in China that are constrained because there are no capital markets for mid-sized companies.

Brennan: Some people use the term junk bonds. You seem to be avoiding using the term. Why?

Sorte: We tried not to use the term junk bonds because we felt it was pejorative to the companies. Certainly the companies didn’t feel like they were junky companies. We used the polite term but obviously junk bonds was the popular name for them and it’s become well accepted.

Brennan: It’s still hard for you to say it, even 20 years later?

Sorte: It is. It was well ingrained into me that we never call them junk bonds.

To contact the reporter on this story: Peter J. Brennan in Los Angeles at pbrennan3@bloomberg.net.

Last Updated: April 14, 2009 00:01 EDT