3. Innovations in Business Finance

For the layperson, few subjects are more daunting than business finance, which seems laden with inscrutable concepts, mysterious jargon, and mathematical formulas. Experienced practitioners might as well be speaking a language of their own.

But even the most sophisticated applications have a clear-cut principle at their core: This is the business of financing business—finding ways to propel growth, create jobs, and bring new ideas to the marketplace. Companies need to select the appropriate capital structure (a mix of various types of short- and long-term debt and equity) to finance their operations and growth. Whether the question is extending credit to an entrepreneur who wants to open a neighborhood shop or helping a multinational corporation restructure its debt burden in a cash crunch, every business needs the right kind of financing at the right time in order to succeed.

The recent financial crisis drove home this simple truth. To the untrained observer, corporate finance might have once seemed to be an academic exercise—the dry rearranging of figures on a balance sheet. But as U.S. credit markets swung from freewheeling to frozen, business financing was revealed to be the lifeblood of the U.S. economy. Highly leveraged firms scrambled to find the right fixes that would enable them to stay afloat, while small companies struggled to get the loans they needed for equipment, supplies, and payroll. The credit crunch immediately translated into job losses and sparked a deep recession. It became abundantly clear that the economy can’t function when individual companies lose the ability to manage their cash flow and obligations in a manner that matches the circumstances.

Even in good times, corporate finance provides the tools that keep commerce humming. In bad times, however, these tools can make all the difference in determining whether an enterprise survives or shutters its doors.

Under normal conditions, business investment is mostly financed by internal cash flow (in accounting terms, depreciation and retained earnings). But the ability to raise external financing spells the difference between stagnation and growth, entropy and innovation. Internal cash flows generally cannot meet the total capital needs of firms and projects, especially for those enterprises focused on future developments and expansion, not only on current operations.

The ability of firms to access capital through the equity and corporate bond markets is critical to driving growth. That door slammed shut in the face of a financial hurricane in 2008. As the Great Recession descended, the tap ran dry and economic growth hit a wall.

Small businesses, a crucial engine of jobs and economic growth, were particularly hard hit by these events. A 2009 survey found that more than one-third of small business respondents were unable to get the financing they needed to run their operations. A similar number reported worsening terms for lines of credit and credit cards.¹

Uncertainty, the enemy of capital markets, always increases during economic crises. Suppliers become reluctant to ship materials to any enterprise struggling under a heavy debt load; many demand cash on delivery because they fear becoming a long-term creditor of a company whose debt is selling at a deep discount. Formerly routine credit transactions become increasingly unavailable, even to solvent firms, because suppliers worry that their bills might not be paid.

But necessity remains the mother of invention. Just as the painful recession of the 1970s gave rise to a great wave of innovation in designing capital structure, the same story will be written one day about the solutions devised to resolve today’s extreme economic challenges. Many businesses caught in this perfect storm have managed to navigate through it by coming up with shrewd approaches to restructuring. Especially during periods of rising defaults, creative approaches to financing and refinancing can enable firms to survive, reorganize, and reinvent themselves to adapt to new market conditions. The innovations that emerge in this field today will be the signposts that lead us out of the Great Recession and back to productive lending and real job growth.

Capital Structure Matters

Growth—those pioneering, building, or restructuring strategies that corporations employ to reinvent themselves, forge new markets, or even conjure up wholly new industries—occurs largely on the cutting edge of the total population of firms and projects. Small, risky, and rapidly growing firms tend to rely more heavily on stock issues and access to private and public capital markets. The innovations applied to devising new capital structures are critical in providing firms with the right mix of securities and financing resources they need to fund real investment and expansion.

Leverage in capital structure is inherently neither good nor bad. For some companies, debt is an important and effective part of their capital structures; other companies in volatile industries should avoid debt entirely. The key is finding an optimum and flexible ratio of debt and equity as market conditions change.

The demand for capital and the typical debt-equity ratio vary widely across industries. Oil companies, utilities, and the chemical, transportation, telecommunications, forest products, and real estate development industries all rely heavily on debt for external financing. Pharmaceutical companies tend to have negative debt ratios, with liquid assets (holdings of cash and marketable securities) exceeding their outstanding debt. Debt ratios are low when profitability, growth opportunities, and business risk are high.² Lower debt means firms have financial slack that allows them to take advantage of good investment opportunities or withstand any unexpected shocks.

In a perfect world (or, at least, that theoretical Neverland imagined by economists, where all things work without friction), gaps in capital structure would always be bridged. Firms would have access to capital based only on their business risk and not on the cost of available financing. That is not, however, how the capital markets currently work. In theory, capital should always flow to its most efficient and best use—yet it doesn’t. In the economic models we build, we’d like to assume that capital markets would be competitive, frictionless, and complete. Alas, they are not. Ideally, the risk characteristics of every security issued by a firm could potentially be matched by purchase of another existing security or portfolio. But the pattern of financial crises and the reality of trading desks in a panic prove that things don’t always play out that way.

The practice of finance strives to continually improve conditions to more closely resemble that ideal world of theory, striving to make it a reality in the rough-and-tumble, trial-and-error environment of the marketplace—a setting in which we learn as we go and sometimes even manage to tease out solutions by empowering firms, entrepreneurs, and innovators.

As entrepreneurs pursue their ideas and ambitions in hopes of seeing an eventual payday for their personal risk taking and sweat equity, financial capital comes in to coinvest, bringing with it similar expectations about the future. The process of creating capital structures that align the interests of owners and investors mobilizes the resources of the capital markets and sets creativity in motion.

As Bradford Cornell and Alan Shapiro have shown, innovations in business finance frequently center on selling off parts of a firm’s cash flow pie in order to grow that pie. As a firm needs more money to grow, it sells off future cash flows generated by its current and future projects. It can do this through selling all rights directly through equity or, as we shall see, repackaging those cash flows into debt instruments, equity-participating debt instruments, or hybrid products that combine characteristics of both debt and equity. (The boundaries between those categories are increasingly blurring as the world of corporate capital structures grows ever more complex).³ Innovations have emerged to match the needs of firms and investors, increase liquidity, reduce transaction costs, and overcome information asymmetries between those inside the firm and outside investors.

Corporate managers and investment managers now have a wide range of tools at their disposal as they go about the business of accessing capital.⁴ This chapter does not delve into technical textbook definitions, nor does it attempt to provide a comprehensive catalog of all the strategies, formulas, and concepts that comprise this field. Instead, it traces how their increasingly sophisticated development and application has fueled more than two centuries of dramatic U.S. economic growth.

One crucial point merits reiterating: Like a road paver’s jackhammer or a miner’s pick, a financial tool is nothing more than an instrument for shaping other objects (in this case, the real economy). Some of these tools remain exotic instruments that are (or should be) used only by the most expert specialists. Others have become common features of the financial landscape. Just as it’s not smart to try your hand at shaving with a lawnmower, it is critically important to choose the right financial tool, customize it to the situation at hand, and use it with care (see Table 3.1).

Table 3.1. Types of Innovations for Business and Corporate Finance

The Birth of U.S. Corporate Finance: Enter Alexander Hamilton

Private corporate finance has public roots, reaching all the way back to the nation’s infancy. When public buildings, roads, or other enterprises required funding, Americans generally refused to put up with new taxes (in a refrain that has been with us for centuries). On occasion, they would resort to borrowing long and short term; but more often, in the early days, the need for capital was satisfied by running lotteries. According to one study, 158 of them were held between 1744 and 1774. The Revolutionary War effort itself received support from lotteries, as did the construction of the nation’s capital city and its first universities.⁵

At a time when capital was scarce, Alexander Hamilton, the first U.S. Secretary of the Treasury, had a notion that lotteries could be used to fund businesses. Given the economic climate of his day, it was not surprising that he considered lotteries the obvious and most efficient method of raising needed capital.⁶ But in the long run, lotteries would not be enough.

As many historians have recounted, Hamilton’s clashes with Thomas Jefferson were notoriously fierce. One of their biggest bones of contention was Hamilton’s belief that government should take a more active role in the economy. When Hamilton took the Treasury’s helm in 1789, the new nation was groaning under the weight of $54 million in debt inherited from the Confederation government. If credit ratings had been given in those days, the United States might have been BBB. Interest rates were high, the political situation was dicey, and capital was hard to come by for both continuing businesses and new ventures. Lenders were unwilling to assume risks, and borrowers were unwilling or unable to pay the high interest rates they demanded.

Hamilton’s actions can still serve today as a template for nations in financial distress. He dismissed out of hand any suggestion of default or bankruptcy, insisting that America’s reputation would never recover from such actions. Instead, he proposed a multipart program to establish the nation’s credit, creating a climate that would give borrowers and lenders the confidence to exchange business debts.

Hamilton set to work restructuring the young nation’s sovereign debt through a debt-for-debt exchange. He focused first on repaying some $11.7 million in foreign debt, a move he executed by issuing new certificates in place of the old, depreciated ones. Two-thirds of the newly issued bonds would pay 6% interest from the origination date of January 1, 1791 (at a time when similar European bonds paid between 4% and 5%). The other third would pay interest after 1800.⁷ In modern parlance, the latter were zero coupons for the first nine years and sold at a discount to reflect this, sparing the government from the burden of making those interest payments during a shaky period.

Next came a recommendation that the federal government should assume state debts (to bind the states to the union). This proposal elicited howls of outrage from states that had no or little debt, while thrilling those states that relished the opportunity to have someone else pay their bills. This plan angered Hamilton’s opponents, who organized to defeat the program.⁸

To advance his plans, the secretary recommended the creation of a Bank of the United States to serve as the government’s depository and fiscal agent. The bank, through its branches, would provide a national currency in which borrowers and lenders alike could have confidence. The First Bank of the United States was founded in 1791 and lasted until 1811. The 1792 Mint Act established a bimetallic standard, ensuring that the government would pay its debts in legal tender instead of the dreaded paper money.

As expected, prices rose on Confederation and state bonds in late 1790, as it became clear that Hamilton’s plan would win the day. In fact, bondholders were so sure of the success of the Hamilton program that, by January 1, 1791, those 6% certificates were selling at 20% above par, and interest rates declined down the line.

By creating the system of public credit, Hamilton was able to promote the public good by making investment safer and easier. This laid a foundation for the development of large-scale business finance. His bold moves constituted the first of many institutional breakthroughs in creatively financing U.S. economic expansion.⁹

The Nineteenth Century Ushers In Rapid Innovation

Hamilton’s First Bank of the United States was followed by the Second Bank of the United States, which lasted from 1816 to 1836, and there was considerable distrust of the concentration of power these institutions represented. In a report on the Second Bank, John Quincy Adams wrote, “Power for good is power for evil, even in the hands of Omnipotence.”¹⁰

The controversy came to a head in the debate on rechartering the Second Bank in 1832. Although Congress passed the bill, President Andrew Jackson successfully vetoed it. A strong bias toward decentralizing the banking system emerged, along with an aversion to powerful financial institutions of any kind. As a result, the U.S. banking system remained highly fragmented throughout the nineteenth century. Unlike every other industrializing country, the United States failed to develop nationwide banks with extensive branching networks. But this vacuum strengthened the role of financial markets and created a wide-open playing field for financial innovation.

In the last half of the nineteenth century, the New York market grew in prominence, due in part to bonds issued during the Civil War and the active trade in them during the following decades. This era witnessed a host of innovations, including the development of the market for commercial paper, which allowed corporations with a strong financial position to borrow short term in the markets more cheaply than they could borrow at a bank.¹¹

As the nation emerged from Reconstruction, the Herculean task of building railways to span the sprawling North American continent offered another proving ground. The vast scale of the undertaking, the enormous capital it entailed, and the constant reorganizations of the railroad companies themselves came to define the great period of American development and innovation that we turn to in the following section.

As Peter Tufano has documented, many of the standard contract forms we still use today—preferred stock, convertible bonds, warrants, and bond covenants—were instruments developed and refined during this period of rapid technological invention and commercialization.¹² Preferred stock was used to raise capital for railroads between 1843 and 1850; it constituted 42% of the capitalization of trusts, mergers, and recapitalizations from 1890 to 1893, and 13% of the total value of securities issued between 1919 and 1927. Income bonds, a type of debt security in which only the face value of the bond is promised to the investor (with coupon payments occurring only with sufficient income earned), were advantageous for distressed railroads facing reorganization during the late nineteenth century. Convertible bonds and notes, devised in the late 1850s, accounted for 13% of bonds issued from 1914 to 1929.¹³ This era saw major strides in the means and methods available for supplying capital.

J.P. Morgan and the Twin Transformations of Industry and Finance

The close of the nineteenth century saw the rise of financial capitalism. Investment banking became a powerful force in the American economy after the Civil War—and J.P. Morgan was the living, breathing symbol of this era.¹⁴

Born into a family of London bankers, Morgan made his first important splash in 1879, successfully selling 250,000 shares of New York Central stock for the Vanderbilt interests. This move demonstrated that Morgan had “placement power,” meaning that he could distribute large amounts of securities without disturbing the market. This ability, earned by providing results for customers, was—and remains—the key to an investment banker’s prowess.

During the next 15 years, Morgan’s attention was focused on railroad reorganizations: working with the Northern Pacific, arranging a truce between the Pennsylvania and the New York Central, and restructuring the Baltimore & Ohio and the Chesapeake & Ohio. By the early 1890s, he had a hand in reviving the defunct Richmond & West Point Terminal Co., which he folded into the Southern Railway Co. and then into the Erie and the Philadelphia & Reading Railroad.

In the course of these projects, banks began to develop close relationships with clients. Indeed, the practice was known as “relationship banking.” Bankers served on their clients’ boards of directors and were kept on retainer for their advice on a wide variety of matters beyond financing.

By the early 1890s, the railroad system was mature, and its presence helped to create manufacturing companies that could operate nationwide. Railroads, telecommunications, and financial enterprises were once the only private firms using the capital markets to sell major bond issues, but now a handful of industrial companies began to approach the market. When they did, debt financing rather than stock issues prevailed, since the investing public remained skeptical about common stocks.

At first, these industrial companies did not seek out the services of investment banks. Companies hoping to raise funds through borrowing turned to “loan contractors,” who arranged loans based on collateral. Some commercial banks would finance local enterprises, and occasionally a broker would canvass his investors to discover whether there was any interest in making loans. Several individuals, such as Charles Ranlett Flint and John W. “Bet a Million” Gates, were promoters who would go from one deal to another, bringing parties together and then presenting the results to an investment banker to arrange the financing. In any case, manufacturing operations in this period were modest affairs, usually owned and managed by their founders. Common stock offerings for industrial companies were rare.

By the early twentieth century, investment bankers had replaced promoters and loan contractors as the principal source of financing for industrial companies. In addition, they extended their influence throughout the economy, forming alliances with commercial banks and insurance companies. Into the Morgan orbit came First National Bank, Chase National, Banker’s Trust, and Guaranty Trust.

The investment bankers’ clients were governments and big business, and the resulting alliance dominated corporate America until the 1980s. In the course of his long and productive life, Morgan led the restructuring of many railroads and industrial corporations and even swooped in to help save government finances during the currency crisis of 1896, the railroad crisis in 1898, and the credit crunch of 1907. Yet he did little to provide small businesses and individuals with greater access to capital. As Alvin Toffler and Bradford DeLong have described, Morgan’s organizational strategies and financial methods were geared toward large-scale industrial consolidation and concentration—in striking contrast to the financial innovations and corporate strategies that were to generated broader entrepreneurial capitalism during later periods.¹⁵

An Age of Creative Destruction

As the curtain fell on the nineteenth century and a new era dawned, advances in financing paved the way for the shift from steam power to electrification, from coal to oil, and from rail to auto. These shifts drove innovation and expansion, and built new fortunes. From 1880 to 1913, the gold standard spread, joint stock banks competed with merchant banks, and the world witnessed an explosion of new corporations and stock offerings. Futures markets in organized commodity and currency exchanges grew, and corporations tried on new organizational forms, including holding companies, trusts, and other corporate or trading entities.

Almost overnight, it seemed, finance made it possible for marvelous new inventions to hit the market: electric generators, dynamite, photographic film, light bulbs, electric motors, internal combustion engines, steam turbines, aluminum, prestressed concrete, and rubber tubing.¹⁶ By the 1920s, the U.S. Patent and Trademark Office was granting record numbers of patents. This epoch of technological progress was marked by the emergence of major corporations built on these advances—and by a new realization that investing in intangibles could lead to very real returns.¹⁷ The growth in the number of investors, along with the increased willingness to take risks for capital gains, drove financial innovation.

Innovation materializes at the nexus between finance and technology. From this intersection, Joseph Schumpeter constructed his complex but compelling theory of business cycles. The gales of “creative destruction,” he observed, rendered old investors, ideas, technologies, skills, plants, and equipment obsolete in the continuous drive to improve productivity, efficiency, and standards of living. This period of history proved that human knowledge and creativity could be monetized through innovation and catalyzed by finance, leading Schumpeter to map out his ideas of dynamic entrepreneurial capitalism and cast aside the static equilibrium models that the economists of his day favored.¹⁸

Business failures also hastened the development and adoption of new securities. Between the Civil War and the Great Depression, the United States lurched through 20 recessions and 15 major bank panics and financial crises.¹⁹ The reorganization of railroads and the improvisation of financing that often accompanied restructuring related to bankruptcies opened new avenues for innovations in business finance. As costs outstripped their original estimates in the building of railroads and industrial plants, preferred stocks enabled near-bankrupt firms to raise additional funds. Long-maturity bonds arose in the late nineteenth century and were used repeatedly for reorganizations through the Great Depression.

Another innovation at the beginning of the twentieth century came in the form of warrants. These were usually issued with bonds or stocks and essentially consisted of an option that allowed the holder to buy stock at a predetermined amount for a limited amount of time. They were first deployed when the American Power and Light Company issued 6% notes in 1911. They were sporadically used until 1925, when they enjoyed wide popularity for several years.²⁰ Warrants would reemerge as valuable tools in the 1960s, as we shall see later in this chapter.

Many decades later, during the credit crunch and business crises of the 1970s and 1980s, the financial innovations of this earlier period would resurface as useful building blocks. Expanding on these earlier advances, financiers found new ways to allow for balance sheet and operational restructuring. Firms came to enjoy flexibility in adapting their capital structures to market conditions: selling debt or equity, for example, or exchanging one for the other when market conditions were most receptive, without tax consequences, to strengthen their balance sheets. Having the opportunity to deleverage (that is, to reduce debt) was a fundamental reason why relatively few companies defaulted in the 1970s and 1980s. Many companies whose debt was considered extremely risky in the 1970s—such as Westinghouse, Tandy, Chrysler, and Teledyne—found ways to manage their capital structures and return to profitability. In the early 1980s, firms such as International Harvester, Allis-Chalmers, Mattel, and Occidental Petroleum were able to deleverage by issuing equity in exchange for debt. They were able to attract investors, maximize shareholder value, and often forestall bankruptcy, thus preserving jobs even as the economy stalled.

A. P. Giannini and the Democratization of Capital

Through the efforts of Morgan and others, a great number of financial innovations increased access to capital for larger enterprises. Corporate and industrial power was concentrated in these behemoths and centralized in Wall Street banks. But soon the doors were destined to swing wider.

The initial attempt to pry open capital access to the broader public began in commercial banking—and it was the brainchild of a man who seemed to be the polar opposite of the august J.P. Morgan. A continent away from Wall Street, Amademo Peter Giannini was born in California in 1870, the son of an Italian immigrant farmer.²¹ Giannini attended school until the age of 14, when he joined his stepfather in the fruit and vegetable trade. There he gained the hands-on experience in small business that would shape his worldview.

In 1903, Giannini took over his deceased father-in-law’s properties, including a minority interest in the Columbus Savings Association. Suddenly, the young vegetable merchant was a banker. In 1909, he formed the Bank of Italy—the institution that would later become Bank of America.

In those days, American banking was dominated by East Coast titans who catered to institutions, corporations, and the upper crust. These banks made loans to only the most creditworthy customers—and modest, immigrant-run enterprises need not apply.

From the first, Giannini focused on small depositors and borrowers, intending to open banking to the masses. His turning point came with the 1906 San Francisco earthquake and fire. When the larger banks had to close down in the aftermath of the disaster, he pitched his tent on a pier and made loans to distressed businessmen on the spot. The legend of A.P. Giannini was born.

Within a few years’ time, he was opening branches in other parts of California, beginning with San Jose, all concentrating on the same small depositors and borrowers that had made the San Francisco bank so successful. Giannini made no secret of his ambition to go national (and even international); in 1928, he even changed the bank’s name to Transamerica. The success of this upstart riled Wall Street and Washington, but despite their efforts to cook up regulations to thwart him, Giannini’s bank had become the largest in America by 1945.

Giannini’s popularization of small business loans and home mortgages began to shape emerging public policies regarding capital access. His move to democratize commercial banking contributed to the explosive growth of California’s agricultural economy and its real estate and entertainment industries (he even bankrolled the first Disney films).

Another revolution of access was also taking place around this time as the first form of mutual funds opened a new channel of capital for business finance. John Elliott Tappan was among the handful of financial innovators seeking higher yields for thrifty small savers. He devised a new method of mobilizing funds, selling face-amount certificates that could be purchased by ordinary folks paying monthly installments over several years. Paying a higher compound interest rate than was available from banks or other traditional financial intermediaries, Tappan founded Investors Syndicate. (Later called Investors Diversified Services, the firm would eventually be acquired by American Express, then spun off to become Ameriprise Financial.²²) His instruments were backed by first mortgages and became a modern, liquid alternative to real estate or land for urban Americans who no longer earned their income from agriculture. His financial innovations informed the development of the life insurance industry, opened the market to small investors, and paved the way for the modern-day mutual fund industry.²³

The 1950s: Rise of the Capital Markets and the Birth of Venture Capital

The first reliable census of stockholders took place in 1952, when a NYSE-sponsored study reported 6.5 million individual shareholders.²⁴ It was in this period that Charles Merrill became to stocks what Giannini was to deposits and business loans. By popularizing ownership of securities, he spawned continuous waves of financial innovation between World War II and the end of the twentieth century.

Merrill began his efforts before World War I but met no real success until after World War II. In those somnolent years, he revolutionized the brokerage community, convincing the broad middle class that investing in stocks was a sensible and even prudent move.

This was no easy task. The average Joe had not participated in the raging bull market of the 1920s but had plenty of all-too-vivid memories of the crash and the Great Depression. Most Americans simply had no interest in stocks—and lacking a broad base of investors, many fledgling companies couldn’t hope to attract financing. The banks and bond markets both shunned start-ups. Bond buyers of this period were not inclined to gamble on young firms with great ideas but no proven track record. Most established investment banks were conservative through and through when it came to deciding where to put their clients’ money. Institutional investors had no interest in pioneering broader ownership or more innovative financing. When Merrill commenced his campaign for “people’s capitalism” after World War II, only 11% of the U.S. population owned equities. Within two decades, that number had risen to one in six Americans, including more than 30.9 million shareholders.²⁵

Merrill got his start during a time when small new investment banks and regional firms began underwriting local issues of manufacturers in emerging industries. With the demise of the Consolidated Exchange in the 1920s, the New York Stock Exchange had taken center stage. However, the Curb Exchange (later rechristened the American Stock Exchange in 1953) gained greater respectability, especially as a secondary market for issues of innovative companies. More than 30 organized exchanges arose outside of New York City in major cities; significant over-the-counter (OTC) markets took hold as well. New sources of reliable business information became available. Class-A common stock—a post–World War I innovation—achieved new popularity in the mid-1950s, offering investors noncumulative participating dividends without voting rights. Securities design for such Class-A common stock incorporated and required new information about company performance and cash flows into new contracts and monitoring of firm performance.²⁶

Until common stock offerings became more viable in the 1950s, the only course of action for young companies and potential startups came from the earliest forms of private equity and venture capital. Two seminal figures in the development of these markets were George Doriot, a former general affiliated with Harvard Business School, and MIT president Karl Comptom, who effectively launched the venture capital industry in 1946 with the founding of American Research and Development (ARD), a publicly traded closed-end fund marketed mostly to individuals.

Doriot had a nose for sniffing out the most promising entrepreneurs, and he found two in Kenneth Olson and Harlan Anderson, who wanted to start a firm to manufacture small computers. They had no money, no credit, and, apparently, no hopes when they incorporated Digital Equipment. But Doriot was willing to help out. In 1956, he offered to invest $70,000 in the company in return for a 60% stock interest; Olson and Anderson eagerly accepted.

By 1958, the first venture capital limited partnership was formed: Draper, Gaither, and Anderson. Start-ups soon had another option, too, in risk-capital pools federally guaranteed under the Small Business Investment Companies (SBIC) program. Soon growth equity and leveraged buyouts were scaling up, trying to overcome the fundamental problems of business finance: illiquidity, uncertainty, and information gaps, and the macroeconomic cyclicality of business formation.²⁷ They were able to do so by incorporating reporting that was required by active investors; these included close monitoring of operations, active board involvement, and intervention to protect both minority shareholder and creditor interests. As Sputnik galvanized interest in government commitments to new technology, firm financings began anew.²⁸

Initial public offerings (IPOs) became another important tool for new and old businesses alike to access the capital markets. In 1956, Ford went public by selling 10 million shares to raise $658 million.²⁹ IPO activity picked up briskly after that and became a full-fledged fad by 1960.

At first, most offerings were made by old-line investment banks that wouldn’t touch a company with less than a five-year record of successful operations. These banks had reputations to safeguard and weren’t about to trade them for quick one-time profits. Then, as the mania gathered steam, marginal underwriters sprouted to peddle low-grade merchandise.³⁰ They were more salesmen than bankers, small-timers who operated on shoestrings and weren’t in business for the long haul. Their operations were legitimate enough but were laced with dubious practices (a common enough occurrence when worthwhile movements hit the mania stage). The later absorption of IPOs into white-shoe investment banking would not happen until the high-tech boom that began in the 1980s.

The IPO craze fell out of favor as a bull market ground to a halt in 1968–1969. Once more it became difficult for start-ups to obtain financing. But this time the situation was mitigated by the continuing growth of venture capital. By the 1970s, VC had become firmly established as a crucial source of funding for up-and-coming firms in new industries.

From Recession to a Revolution in Corporate Finance

During the 1950s and 1960s, when inflation was low, interest rates were stable, and the United States faced little international competition, financial planning was not a top concern for corporate managers. Financing, for many companies, involved little more than balancing the corporate checkbook.

This was, however, an unusually fruitful period for high-level theoretical thinking that laid the groundwork for further financial innovation. In 1958, professors Franco Modigliani and Merton Miller (both of whom would later win Nobel prizes) published a groundbreaking article titled “The Cost of Capital, Corporation Finance, and the Theory of Investment.” The Modigliani–Miller (or M&M) theorem posits that, under perfect market conditions, the value of a firm is independent of its capital structure. This theorem launched a new way of thinking about capital structure, and a generation later, researchers are still analyzing how real-world frictions impact the theorem’s idealized assumptions.

The early 1960s also saw the introduction of the Capital Asset Pricing Model (CAPM), a formula for pricing securities based on the expected rate of return plus a risk premium, and Monte Carlo methods for valuing complex instruments by shifting uncertain variables in simulated outcomes and averaging the results. These conceptual breakthroughs (along with the 1973 Black–Scholes option pricing model, which paved the way for an explosion of activity in new derivative markets) were explained in greater detail in Chapter 2, “A Framework for Financial Innovation: Managing Capital Structure.” Their appearance greatly broadened the possibilities and technical sophistication of corporate finance.

Moving beyond the realm of theory, the pace of real-world financial innovation quickened sharply in the 1970s, born out of a bitter recession in which interest rate spikes and skyrocketing energy prices followed hard on the heels of a stock market collapse.

Many firms needed to restructure themselves in order to survive; others were eager to commercialize exciting new technologies despite the tough environment. As the downturn took hold in 1974, banks curtailed lending to all but the largest and highest-rated companies, while the most innovative firms—those with the highest returns on capital and the fastest rates of growth—were shut out. This pent-up need for capital provided the impetus for another leap forward in the field of corporate finance.

Building on the research of W. Braddock Hickman and others, who discovered that below-investment-grade debt earned a higher risk-adjusted rate of return than investment-grade bonds, financier Michael Milken realized that premium high-yield bonds more than compensated investors for the added risk of default.³¹ He soon built a vast market for high-yield debt that provided innovative companies with the ability to finance growth and the flexibility they needed to manage their capital structures in changing times.

High-yield debt (known pejoratively as “junk bonds”) was not an entirely new concept, but the market for it had shriveled up for most of the twentieth century. Before the 1970s, virtually all new publicly issued bonds were investment grade—and only the debt of large ultra-blue-chip companies fell into this category. Until this time, the only publicly traded junk bonds were issues that had once been investment grade but had become “fallen angels,” undergoing downgrades as the issuing company fell into financial distress. The interest payments on these bonds were not high, but with the bonds selling at pennies on the dollar, their yields were tempting. Companies deemed speculative grade were effectively shut out of the capital market and forced to rely on more expensive and restrictive bank loans and private placements (which involve selling bonds directly to investors such as insurance companies).

Milken realized that the debt market for fallen angels and troubled securities could have a wider purpose: It could be utilized to create securities for up-and-coming companies that simply needed access to capital. After all, tens of thousands of publicly traded firms (in fact, 95% of the publicly traded companies with more than $35 million in revenues) were not being served by the corporate bond market.³²

The “junk bond revolution” began in 1977, when Bear Stearns underwrote the first new-issue junk bond in decades and Drexel Burnham Lambert developed new-issue high-yield bonds for seven companies once shunned by the corporate bond market. Companies could now issue bonds that were below investment grade from their inception.

Because high-yield bonds are deemed to be riskier than other types of debt, they typically promise higher yields than investment-grade bonds. It began to dawn on investors that junk bonds could actually outperform investment-grade bonds over time, and they flocked to this new market. From 1979 to 1989, the high-yield debt market grew almost 20-fold, to almost $200 billion.³³ Junk bonds financed the successful restructuring of numerous manufacturing firms, including Chrysler.³⁴ The subsequent use of these instruments as a component in hostile takeovers eventually produced a strong backlash, but the primary function of the high-yield market was providing capital for corporate growth, expansion, and survival.³⁵

Financial instruments had traditionally been lumped into categories based on whether they related to debt or equity, but in recent decades those distinctions have blurred. Changes in the corporate bond market and the growth of structured finance in fixed-income asset classes enabled greater flexibility in managing corporate capital structures, and a wide array of products emerged to help corporations lower the cost of capital and account for various types of risk.

Bond-warrant units offer a prime example. Corporations could exchange these hybrid securities (combining equity and debt components) for the assets of companies they were seeking to acquire. This type of instrument was first used in the 1960s in deals such as Loews Theatres’ acquisition of cigarette manufacturer Lorillard; the transaction involved Loews exchanging $400 million in 15-year, 6.875% bonds and 6.5 million warrants.³⁶ Almost $1.5 billion of these types of transactions were completed in the late 1960s and early 1970s.³⁷

Recession gave way to recovery in the early 1980s, but stock prices, though rising, were still considerably below replacement costs. Companies were hesitant to embark on new common stock offerings that might dilute the holdings of existing shareholders. Interest rates were declining but remained historically high, making the prospect of long-term borrowing equally unappealing.³⁸ Bond-warrant units proved to be a good tool for resolving this dilemma. They made the dilution of ownership more palatable because they were exercisable above the current market price; they substantially reduced borrowing costs while allowing companies longer time horizons for repayment.

Dozens of non-investment-grade companies had opted to issue bond-warrant units by 1983; cumulatively, they raised almost $3 billion through this avenue.³⁹ Golden Nugget sold $250 million in these instruments to expand operations in 1983; three years later, MGM sold $400 million in 10% bond-warrant units to refinance the bank debt used in its acquisition of United Artists.⁴⁰

MCI stands out as one of the largest such offerings in this time period. Its management had been consumed with the never-ending task of raising short-term capital to build an ambitious long-distance network; however, in 1983, the company issued $1 billion in 10-year bond-warrant units with a coupon of 9.5%, substantially less than what U.S. Treasuries were yielding at the time. Now the company had the capital—and the freedom—to focus on creating a cutting-edge fiber-optic telephone network even though the profits it would generate remained further down the road.⁴¹

As with MCI, other growth-oriented companies needed to finance the buildout of new technology infrastructure. They needed the right capital structure to survive and thrive until that investment could pay off. Zero-coupon, payment-in-kind (PIK), and split-coupon securities emerged as additional financial tools for the task. These debt securities are sold below face value because they promise no periodic cash interest payments. Instead, the interest is internally calculated based on time to maturity and credit quality. The buyer of such a bond receives the rate of return by the gradual appreciation of the security, which is redeemed at face value on the maturity date. In the case of a PIK, the issuer is given the option to make interest payments in additional securities or in cash, providing flexibility in regulating cash needs for the enterprise.

In April 1981, J.C. Penney made a public issue of zero-coupon bonds.⁴² This offering, along with a tax benefit that existed at the time, boosted the popularity of these instruments. Although the tax loophole was quickly closed when firms started taking advantage of it on a large scale, the market for zero coupons nevertheless continued as investors found their payment characteristics desirable because of a lack of reinvestment risk. Investment banks initially stripped government securities to satisfy this demand, but eventually the Treasury stepped in and took over this role.⁴³

Firms such as McCaw Cellular, Turner Broadcasting, and Viacom International were burning through current cash flow to expand their cellular telephone networks, cable television programming, and cable television systems, respectively—so they turned to the high-yield market to finance growth. In 1988, McCaw issued $250 million in 20-year discounted convertible debentures paying no cash interest for 5 years, freeing up cash flow for expansion. (The firm later merged with AT&T in 1994.) Turner Broadcasting issued $440 million in zero-coupon notes that deferred interest payments until maturity. Viacom issued $370 million in PIK securities, with the flexibility to pay interest in additional securities rather than cash.⁴⁴ Time-Warner, News Corporation, and other firms used similar financing strategies to transform the way we use media, communications, and information technology.

Commodity-linked securities also came into vogue during this time period. In 1980, Sunshine Mining issued the first silver-backed, commodity-indexed bonds in 100 years.⁴⁵ By linking these securities to the price of silver, Sunshine could pay about half the interest rate of a straight debt issue (about 3% less than what U.S. Treasuries were paying at the time). Investors shared in the profits when the price of silver rose—and this paid off handsomely at various points. Meantime, Sunshine lowered its cost of long-term capital.

All of these innovations in corporate high-yield debt instruments involved some form of risk reallocation. Zero-coupon bonds enable interest to be effectively reinvested and compounded over the life of the debt issue. Interest-rate risks can be managed through adjustable-rate notes and floating-rate notes, while commodity-linked bonds address price and exchange-rate risks. Securities can be structured to reduce the volatility of cash flow to the extent if interest or principal payments are associated with changes in a company’s revenues; the debt-service burden is shifted from times when the firm is least able to pay, to times when it is most able to pay. Currency risk can similarly be managed through tools like dual-currency bonds, indexed currency option notes, principal exchange rate linked securities (PERLS), and reverse principal exchange rate linked securities (reverse PERLS).

The advent of information-processing technology (such as credit scoring) and asset-pricing models (such as CAPM, which enables analysis of asset prices based on risk and rates of return of a particular financial asset compared to the overall stock market) gave rise to products that could enhance liquidity. An infinite variety of features attached to bonds and notes reduced agency costs, transaction costs, taxes, and regulatory bottlenecks. This remarkable surge of creativity in the high-yield debt market ultimately spawned additional ideas for preferred stock, convertible debt, and equity innovations.⁴⁶

The Rise of Private Equity and the Decade of the Leveraged Buyout

Private equity came into its own in the 1980s. George Fenn, Nellie Liang, and Stephen Prowse argue that this was due to the widespread adoption of the limited partnership as the means of organizing the private equity partnership. Thanks to this organizational innovation, private equity, once the province of wealthy families and industrial corporations, was now dominated by professional managers acting as general partners (largely on behalf of institutional investors who provide finance as limited partners). This partnership form relied on high-powered incentives to overcome extreme informational asymmetries and incentive problems. Between 1980 and 1995, funds invested in the organized private equity market grew from $4.7 billion to more than $175 billion.⁴⁷

Private equity firms employ a wide range of strategies. Though perhaps best known as a force behind leveraged buyouts (discussed later in this section), they also invest in anything from distressed debt to real estate. Perhaps most important, venture capital (VC) is a subset of private equity. Fenn, Liang, and Prowse argue that the growth in private equity has enabled more funds to flow, both to classic start-up companies and to established private companies.⁴⁸ Between 1980 and 1995, venture capital outstanding grew from $3 billion to $45 billion. VC financed the rise of many of America’s most innovative firms, including Genentech, Microsoft, Oracle, Intel, and Sun. It is fair to say that venture capital played a crucial role in making the United States a leader in high-tech industries, particularly biotechnology and computers.⁴⁹

Nonventure private equity also increased substantially during the 1980s, when blockbuster leveraged buyouts (LBOs) dominated the business headlines, culminating with the $31 billion takeover of Nabisco by Kohlberg Kravis Roberts (KKR). In this type of acquisition, the financial sponsor or a private equity firm uses a significant amount of debt to purchase the target company, sometimes using the target company’s assets as collateral. LBOs, management buyouts, and employee buyouts can, at their best, produce corporate makeovers that result in greater efficiency and competitive advantage.⁵⁰ Although LBOs boomed during the 1980s, severe competition at the end of the decade reduced the profitability of deals as funds were forced to pay more for firms. This led to a fall in the number of LBOs for several years.

The rise of the LBO sparked another set of innovations regarding corporate governance.⁵¹ In response to the increasing number of hostile bids that occurred during this period, a number of antitakeover techniques were developed. Initially, these involved charter amendments, such as supermajority voting provisions that might require, for example, that 80% of shareholders approve a merger. Another example is staggered terms for board members, which can delay transfer of effective control for a number of years.

An important characteristic of charter amendments is that shareholder approval is required. In 1982, an alternative anti-takeover defense was developed to protect the El Paso Company from a raid: the issuance of what came to be known as poison pill securities. There are a number of variations on these, including preferred stock plans, flip-over plans, and back-end plans.

Preferred stock plans were the exclusive tool of choice for fending off takeovers until 1984. With these, the potential target issues a dividend of convertible preferred stock to its shareholders, granting them certain rights if an acquiring party purchases a large position (30% in one plan) in the firm; the board of directors can choose to waive these rights. The preferred stockholders can require the outside party to redeem the preferred stock at the highest price paid for common or preferred stock in the past year. If a merger occurs, the acquiring firm must exchange the preferred stock for equivalent securities that it must issue. These preferred stock plans made it more difficult for raiders to acquire firms by removing an incentive for shareholders to bid early on, because they can always be sure of obtaining the highest price paid.

Crown Zellerbach used the first flip-over plan as a poison pill in July 1984. The first step in executing this strategy is the issue of a common stock dividend consisting of a special form of “right.” This gives the holder the right to purchase common stock at an exercise price well above its current market price. It can be exercised starting 10 days after an outside party obtains or bids for a substantial amount (such as 20%) of the target firm’s stock for up to 10 years. Ordinarily, nobody would want to exercise these rights because the exercise price is well above any likely market price. However, if a merger occurs, they “flip over” and allow the holder to buy shares in the merged firm at a substantial discount. This makes hostile mergers extremely costly, but friendly mergers are still possible because a company can repurchase the rights for a nominal fee unless they have been triggered.

The back-end plan was also introduced in 1984. When acquiring a target, firms often made a “two-tier bid”: They initially paid a high price for a majority of shares and then used their voting power to force a merger at a lower price, so the remaining shareholders did worse than those who initially tendered. This structure provides an incentive for shareholders to tender. Back-end plans are similar to flip-over plans, except the rights issued put a minimum on the amount acquirers must pay in the second part of a two-tier offer.

Consolidation of Innovation in the 1990s and 2000s

After the rapid advances of the 1970s and 1980s, financial innovation for corporations shifted into lower gear. The last two decades have produced incremental rather than revolutionary advances in business finance.⁵² Many of the new instruments were structured products issued by financial institutions instead of new securities to raise funds for corporations. (For example, structured equity products are medium-term notes that have payments based on an individual company’s stock price, a stock index, or multiple indices.) During this period, most of the truly exciting innovation was concentrated in the fields of housing finance and environmental finance (these topics are discussed in subsequent chapters).

There were, however, some noteworthy developments in business finance. One of the most important was the expansion of credit-scoring techniques from consumer loans to small business loans. Credit scoring involves assigning a single quantitative measure to borrowers, indicating their creditworthiness. Originally, it was thought that commercial loans were too heterogeneous to use credit scores, but it turned out that the personal credit history of small business owners was very useful in predicting repayment performance for loans less than $100,000. The adoption of this methodology has significantly changed the way small businesses finance themselves.⁵³

Another important (and soon-to-be-notorious) innovation was the credit default swap (CDS). These instruments allow investors to buy protection, or insurance, against default. In exchange for a regular premium, they provide a payment if a corporation defaults on its bonds. However, credit default swaps are not restricted to corporate debt. They can also be purchased on government debt and other types of debt (including mortgage-backed securities) issued by a variety of institutions. JPMorgan Chase invented credit default swaps in the mid-1990s; the first arrangement involved selling the credit risk of Exxon to the European Bank of Reconstruction and Development.⁵⁴

The “spread” of a CDS is the annual amount of protection the buyer must pay the seller over the life of the contract or until a default occurs. It is expressed as a percentage of the notional amount of protection. A 1% spread on a notional amount of protection of $100 million of a corporation’s bonds would imply a payment of $1 million a year from the buyer to the seller. In the event of a default by the corporation the credit default swap was written on, the seller would pay the buyer $100 million, minus the value of the bonds at the time the payment is made.

The great advantage of credit default swaps is that they allow credit risk to be hedged. For example, the holders of the bonds of a corporation or companies doing business with the corporation could insure against their default. Unfortunately, CDS also provided a tempting vehicle for speculation. The CDS market quickly ballooned, and by the end of 2007, the total notional amount of CDS contracts outstanding was $62 trillion.⁵⁵

During the financial crisis that erupted in 2008, credit default swaps came under severe criticism for magnifying systemic risk. One of the major sellers of CDS was the insurance company AIG. When its capital was impaired by a fall in the value of the mortgage-backed securities it held, the company was downgraded. Its CDS contracts required the company to post a substantial amount of collateral when this happened, which it was unable to do. Rather than allowing AIG to default, the government intervened and took it over. In the end, the federal bailout enabled AIG to pay out $105 billion in counterparty payments.⁵⁶ This move elicited howls of protest, but the government felt compelled to act in order to contain the systemic risk entailed by a potential AIG default, which might have sparked a chain of further defaults among other holders of AIG CDS. The danger of a meltdown of the entire financial system seemed too great.

Going forward, the future of the CDS market is unclear. At the end of the first half of 2009, the total notional amount outstanding had been halved to $31 trillion.⁵⁷ However, apart from the AIG fiasco, credit default swaps worked reasonably well. The CDS written on Lehman Brothers were settled smoothly when it defaulted—and the same was true for 11 other credit events that triggered payments on CDS.⁵⁸

Before the financial crisis, the CDS market had been essentially unregulated as a result of the Commodity Futures Modernization Act of 2000. This will undoubtedly change. There have been many calls for CDS to be traded on an exchange instead of in the over-the-counter market, to improve the transparency of counterparty risk. The market is likely to survive in some form but will probably not see a return to its 2007 peak for some time to come.

The media has frequently singled out credit default swaps as culprits in the financial crisis—but they are simply products, not to be confused with the individuals who misused them. It is a simple fact that new financial products will sometimes fail. At the very least, they present a learning curve and may require serious refinement. But many critics have taken things further, arguing that the way to prevent crisis is to turn back the clock. In our view, we can’t allow this way of thinking to win the day. Sustained long-term growth requires continuous financial innovation so that small and big businesses alike can obtain the funds they need and grow and prosper.

Conclusions

In the last few decades, corporate finance has added new layers of complexity. And yet, for all of the sophisticated computer models and mathematical formulas that have been thrown at the task, devising the best way to finance an individual firm remains something of an art. As Michael Milken, one of the innovators profiled in this chapter, once said:

There is no optimum capital structure—X percent equity and Y percent debt—that can be applied to different organizations, or to the same corporation at different points of time. Just as you can’t make real money by putting a dollar bill on a copying machine, you can’t successfully copy the financing technique that once worked for a particular company and transfer it to another time or another company .... [F]inance is a continuum with infinite variations and hybrids. It takes deep understanding of a company, its environment, and the financing tools available to build sustainable growth that will reward shareholders and create jobs.⁵⁹

Finding the right variables to suit the situation can make all the difference in transforming an innovative start-up into an iconic company. That kind of undertaking equates to more than just a profitable investment. It builds lasting value.

The story of America’s economic expansion is inextricably bound to the advances made in business financing. It is a chronicle of empowering entrepreneurs, launching new industries, and bringing breakthrough technologies to market. Innovative financing strategies have made it possible for companies to meet a host of challenges, from building railways that would span a continent to creating a revolutionary system of commerce in cyberspace.

It’s possible to get lost in the complexity of this field. Business finance is a moving target, constantly evolving to keep up with new markets, new needs, and changing conditions. But today, as we try to shake off the stagnation of the Great Recession, it all boils down to a simple goal: enabling companies large and small to create jobs for a return to prosperity.

Endnotes

1 National Small Business Association, “2009 Mid-Year Economic Report”: 6.

2 Stewart C. Myers, “Capital Structure,” Journal of Economic Perspectives 15, no. 2 (Spring 2001): 81–102.

3 Bradford Cornell and Alan C. Shapiro, “Financing Corporate Growth,” in The Revolution in Corporate Finance, 4th ed., J. M. Stern and D. H. Chew, Jr., eds. (London: Blackwell Publishing Ltd., 2003): 260–277.

4 Much of the discussion in this chapter is based on Glenn Yago and Susanne Trimbath’s Beyond Junk Bonds (New York: Oxford University Press, 2003). See also James R. Barth, Daniel E. Nolle, Hilton L. Root, and Glenn Yago, “Choosing the Right Financial System for Growth,” Milken Institute Policy Brief 8 (February 2000).

5 Charles T. Clotfelter and Philip J. Cook, Selling Hope: State Lotteries in America (Cambridge: Harvard University Press, 1989); and Robert Sobel, The Money Manias: The Eras of Great Speculation in America, 1770–1970 (New York: Beard Books, 2000).

6 Much of the discussion regarding Hamilton is drawn from Ron Chernow’s Alexander Hamilton (New York: Penguin Press, 2004). See also Robert E. Wright, The First Wall Street: Chestnut St., Philadelphia and the Birth of American Finance (Chicago: University of Chicago Press, 2005); and Robert E. Wright and David J. Cowen, Financial Founding Fathers: The Men Who Made America Rich (Chicago: University of Chicago Press, 2006).

7 Theodore M. Barnhill, William F. Maxwell, and Mark Shenkman (eds.), High-Yield Bonds (New York: John Wiley & Sons, 1999); and Stuart C. Gilson, Corporate Restructuring: Case Studies (Cambridge, MA: Harvard Business School Press, 2000).

8 Glenn Yago, Junk Bonds (New York: Oxford University Press, 1993).

9 Michael D. Bordo and Carlos A Vegh, “What If Alexander Hamilton Had Been Argentinean? A Comparison of the Early Monetary Experiences of Argentina and the United States” (working paper no. 6862, National Bureau of Economic Research, December 1998).

10 Richard H. Timberlake, The Origins of Central Banking in the United States (Cambridge, MA: Harvard University Press, 1978).

11 H. G. Guthmann and H. Dougall, Corporate Financial Policy, 4th ed. (Englewood Cliffs, NJ: Prentice Hall, 1962): 465–466.

12 Peter Tufano, Three Essays on Financial Innovation, Ph.D. dissertation, Harvard University (1989).

13 Ibid.

14 This discussion is derived from Robert Sobel, The Pursuit of Wealth: The Incredible Story of Money Throughout the Ages (New York: McGraw Hill, 2000); Ron Cherow, The House of Morgan: An American Banking Dynasty and the Rise of Modern Finance (New York: Atlantic Monthly Press, 1990); and Jerry W. Markham, A Financial History of the United States (Armonk, NY: M. E. Sharpe, 2002).

15 J. Bradford DeLong, “Did J.P. Morgan’s Men Add Value? An Economist’s Perspective on Financial Capitalism,” in Inside the Business Enterprise, Peter Temin, ed. (Chicago: University of Chicago Press, 1991); and Alvin Toffler, Power Shift (New York: Bantam, 1990).

16 Larry Neal and Lance E. Davis, “Why Did Finance Capitalism and the Second Industrial Revolution Arise in the 1890s?” in Financing Innovation in the United States: 1870 to the Present, Naomi Lamoreaux, Kenneth Sokoloff, and William Janeway, eds. (Cambridge: MIT Press, 2007).

17 Tom Nicholas, “Why Schumpeter Was Right: Innovation, Market Power, and Creative Destruction in 1920s America,” Journal of Economic History 63 (2003): 1023–1057. See also Tom Nicholas, “Stock Market Swings and the Value of Innovation, 1908–1929,” in Financing Innovation in the United States, 1870 to Present, Naomi Lamoreaux, Kenneth Sokoloff, and William Janeway, eds. (Cambridge: MIT Press, 2007).

18 Thomas K. McCraw, Prophet of Innovation: Joseph Schumpeter and Creative Destruction (Cambridge, MA: Harvard University Press, 2007).

19 G. W. Schwert, “Business Cycles, Financial Crises, and Stock Volatility,”(working Paper no. 2957, National Board of Economic Research [NBER], March 1990).

20 Arthur Stone Dewing, A Study of Corporation Securities (New York: Ronald Press, 1934).

21 This discussion is largely based on Felice Bonadio’s A. P. Giannini: Banker of America (Berkeley: University of California Press, 1994).

22 Ameriprise Financial, “Key Facts & Milestones,” www.ameriprise.com/about-ameriprise-financial/company-information/key-facts.asp.

23 Ken Lipartito, Investing for Middle America: John Elliott Tappan and the Origins of American Express Financial Advisors (New York: St. Martins Press, 2001).

24 Robert Sobel, Dangerous Dreamer: Financial Innovators from Charles Merrill to Michael Milken (New York: John Wiley & Sons, 1993).

25 Ibid.

26 Tufano, Three Essays on Financial Innovation, Ph.D. dissertation, Harvard University (1989).

27 Josh Lerner, Felda Hardymon, and Ann Leamon, Venture Capital and Private Equity: A Casebook (New York: John Wiley & Sons, 2009).

28 Mary O’Sullivan, “Finance and Innovation,” in The Oxford Handbook of Innovation, eds. J. Fagerberg, D. Mowery, and R. Nelson (New York: Oxford University Press, 2004).

29 Douglas Brinkley, Wheels for the World: Henry Ford, His Company, and a Century of Progress (New York: Harper Collins, 2003). See also T. Loughran and J.R. Ritter, “Why Don’t Issuers Get Upset About Leaving Money on the Table in IPOs?,” Review of Financial Studies 33, no. 6 (2002): 401–419.

30 This discussion is based upon the elaboration of market revival in the 1960s by Sobel, The Pursuit of Wealth (see endnote 14).

31 W. Braddock Hickman, Corporate Bond Quality and Investor Experience (Princeton: Princeton University Press, 1958).

32 Ibid. Yago (1993).

33 Sean Monsarrat, “Economist, Defying Conventional Views, Calls Junk Bonds Corporate Scapegoat,” The Bond Buyer (28 September 1990). See also data from the Salomon Center, NYU’s Stern School of Business, as published in Edward Altman, “Are Historically Based Default and Recovery Models in the High-Yield and Distressed-Debt Markets Still Relevant in Today’s Credit Environment?,” Bank i Kredyt no. 3 (2007) (available at SSRN, http://ssrn.com/abstract=1011689).

34 Thomson Reuters, SDC database.

35 Edward Altman and Scott Nammacher, Investing in Junk Bonds: Inside the High-Yield Debt Market (New York: John Wiley & Sons, 1987).

36 Moody’s Industrial Manual, 1970 ed. (New York: Moody’s Investor Services, 1970).

37 Ibid. Yago and Trimbath (2003).

38 Phil Molyneux and Nidal Shamroukh, “Diffusion of Financial Innovations: The Case of Junk Bonds and Note Issuance,” Journal of Money, Credit, and Banking (August 1996): 502–526.

39 Ibid. Yago and Trimbath (2003).

40 “Briefs: Debt Issues,” New York Times (15 April 1983 and 1 July 1983).

41 James L. Rowe, Jr., “MCI Offer Doubled to $1 Billion; Notes Are Placed Before Scheduled Sale on Monday,” Washington Post (2 August 1983).

42 “Zero-Coupon Issue Is Sold by Penney,” New York Times (22 April 1981).

43 Franklin Allen and Douglas Gale, Financial Innovation and Risk Sharing (Cambridge, MA: MIT Press, 1994).

44 Thomson Reuters, SDC database.

45 “Sunshine Mining Sets First Offer Backed by Precious Metals Since the Late 1800s,” Wall Street Journal (5 February 1980).

46 John Finnerty, “An Overview of Corporate Securities Innovation,” Journal of Applied Corporate Finance 4, no. 4 (1992): 23–39; and Stephen A. Ross, “Institutional Markets, Financial Marketing, and Financial Innovation,” Journal of Finance 44, no. 3 (1989): 541–556.

47 George W. Fenn, Nellie Liang, and Stephen Prowse, “The Private Equity Market: An Overview,” Financial Markets Institutions and Instruments 6, no. 4 (July 1997): 1–105.

48 George W. Fenn, Nellie Lang, and Stephen Prowse, “The Economics of the Private Equity Market,” Federal Reserve Bulletin (January 1996).

49 Andrew Metrick, Venture Capital and the Finance of Innovation (Hoboken, NJ: John Wiley & Sons, 2007).

50 Glenn Yago, Mike Bates, Wendy Huang, and Robert Noah, “Tale of Two Decades: Corporate Control in the ‘80s and ‘90s,” Milken Institute Research Report 21 (November 2000). See also Zoltan Acs, Randall Morck, and Bernard Yeung, “Productivity Growth and Firm Size Distribution,” Milken Institute Research Report (June 1996).

51 The discussion of leveraged buyouts and poison pill provisions draws on Franklin Allen and Douglas Gale’s Financial Innovation and Risk Sharing (Cambridge, MA: MIT Press, 1994).

52 Enrique Schroth. “Innovation, Differentiation, and the Choice of an Underwriter: Evidence from Equity-Linked Securities,” Review of Financial Studies 19, no. 3 (2006): 1041–1080.

53 Jalal Akhavein, W. Scott Frame, and Lawrence J. White, “The Diffusion of Financial Innovations: An Examination of the Adoption of Small Business Credit Scoring by Large Banking Organizations,” Journal of Business 78, no. 2 (2005): 577–596.

54 John Lanchester, “Outsmarted: High Finance vs. Human Nature,” The New Yorker (1 June 2009). Available at www.newyorker.com/arts/critics/books/2009/06/01/090601crbo_books_lanchester.

55 International Swaps and Derivatives Association (ISDA), Market Survey (2007).

56 Lex column, “AIG’s Billions,” Financial Times (FT.com) (16 March 2009). Available at www.ft.com/cms/s/2/a2b7095a-1237-11de-b816-0000779fd2ac.html.

57 ISDA Market Survey (2009).

58 Colin Barr, “The Truth about Credit Default Swaps,” CNN/Fortune (16 March 2009). Available at http://money.cnn.com/2009/03/16/markets/cds.bear.fortune/index.htm; accessed November 10, 2009.

59 Michael Milken, “The Corporate Financing Cube,” Milken Institute Review (Fourth Quarter 2002).