Special Report: Big-Time Buyouts
By Janice Castro
Takeover wars have raged on and off for decades, but corporate America has never seen anything quite like the battle for RJR Nabisco. The combatants are brandishing tens of billions of dollars and mobilizing squadrons of bankers and lawyers on a scale previously unimagined. On one side is the firm of Kohlberg, Kravis, Roberts, until now the undisputed master of the leveraged buyout. On the other is an alliance between a group of RJR Nabisco executives and Shearson Lehman Hutton, an old-line investment firm determined to break KKR's dominance of the hottest, most lucrative business on Wall Street. If either side pulls off the deal, the course of U.S. corporate history could be changed forever.
The contest has already pushed the price for RJR Nabisco above $20 billion, which means that the potential buyout would dwarf the largest previous takeover, the $13.3 billion acquisition of Gulf by Chevron in 1984. The megastakes battle has taken the starch out of corporate chiefs everywhere. After all, if RJR Nabisco, the 19th largest U.S. corporation (1987 revenues: $16 billion), can be taken over by the new breed of dealmakers, is any company safe? Is Du Pont doable? Can General Electric be hot-wired? Worse, must every chief executive view a healthy balance sheet as his worst enemy, a potentially rich source of leverage for a pushy buyer? Concludes James Scott, professor of finance at Columbia Business School: "There is no magic number anymore. There is no safety in size."
The big-time leveraged buyout is one of the cleverest financial gimmicks of all time. An investor group, which often includes some of the target company's top managers, borrows billions to take the firm private by buying its stock from the shareholders. The company's own assets are used as security for the financing. After the deal is completed, the new owners usually try to bring their debt down to a manageable level -- and pick up enormous profits along the way -- by selling off parts of the company piecemeal. In the case of RJR Nabisco, the total market value of popular individual brands like Oreo cookies and Winston cigarettes may be far higher than the $20 billion price tag for the company as a whole.
Buyouts have become so attractive that they are sweeping through corporate boardrooms like no other business fad in memory. In the first ten months of 1988, according to IDD Information Services, a Manhattan research firm, 143 companies were taken private in buyouts worth $91 billion, in contrast to 105 deals worth $36 billion during the same period of 1987. These transactions are enriching shareholders and buyout specialists, but the takeovers could be causing grave damage to U.S. industry. Never before has debt been substituted for shareholders' equity on such a huge scale. No one knows how these highly leveraged companies will fare in the next recession.
The buyout binge is causing concern among U.S. financial regulators. Responding in writing to questions from the Senate Banking Committee last week, Federal Reserve chairman Alan Greenspan said the Fed had cautioned banks about extending loans for leveraged buyouts. He suggested that Congress take a closer look at tax provisions that encourage such buyouts. Greenspan's views sent a tremor through the stock market, and share prices of companies involved in takeovers took a tumble, as many investors turned fearful that the buyout boom could suddenly go bust.
The market was also disturbed by reports that Federated Department Stores, which was acquired by Campeau Corp. earlier this year in a highly leveraged $6.6 billion deal, had withdrawn a $1.2 billion issue of junk bonds because there were not enough buyers. Federated's problems sent a message that financing for huge takeovers may be increasingly difficult to arrange.
Both KKR and Shearson are confident they can raise the money to buy RJR Nabisco, but it will not be easy. KKR has built up a $5.6 billion buyout fund with capital contributed by insurance companies, pension funds and other big investors. With that capital base, KKR has the ability to borrow as much as $56 billion, but how much it can raise for a single takeover remains to be seen. As in past deals, KKR will get part of the money by issuing high-yield junk bonds through Drexel Burnham Lambert. But that financing could be jeopardized if Drexel and its junk-bond wizard, Michael Milken, are indicted, as expected, for securities fraud. As insurance, KKR has also recruited Morgan Stanley and Merrill Lynch to help sell bonds.
In response, Shearson has called in yet another Wall Street firm, Salomon Brothers, to assist in attracting investors. Ultimately, Shearson can draw on the financial resources of its parent company, American Express (1987 revenues: $18 billion).
Neither KKR nor Shearson can finance the takeover of RJR Nabisco without some $12 billion in loans from commercial banks. Already the opposing bidders are lining up commitments from major banks in the U.S., Western Europe and Japan. Says a skeptical Wall Street investment banker: "The two sides are now competing to see how big a mountain of debt they can put on the head of a pin."
It was KKR that first brought leveraged buyouts into the headlines. Founded in Manhattan in 1976 by three men from the Bear, Stearns investment firm -- Jerome Kohlberg, 63, Henry Kravis, 44, and George Roberts, 45 -- the company started out modestly, with friendly deals in which it joined forces with management to take companies private. Among its first targets were U.S. Natural Resources (price: $22 million) and Pack River ($136 million).
But KKR's early success gave it a taste for bigger and bolder deals. By the mid-1980s, KKR started to make unsolicited takeover bids, though the company still does not like to go through with a buyout unless the target firm's board of directors eventually agrees to the deal. Kohlberg left KKR last year because he was concerned about the aggressive course his junior partners were taking.
Under the guidance of Kravis and Roberts, KKR has become a Wall Street steamroller. Its biggest buyouts include the Beatrice food conglomerate for $6.2 billion and the Safeway grocery chain for $4.5 billion. But while KKR is well known as an investment adviser, few people realize that it has become one of the largest industrial holding companies in America. Though KKR readily sells off pieces of the firms it buys, it usually retains some core businesses. Of the 35 companies it has acquired, KKR still has control of 23. As a result, KKR has become a huge conglomerate. The companies it controls produce everything from French colonial furniture to dairy products. If KKR were classified as an industrial company, according to FORTUNE magazine, its estimated $38 billion in annual revenues would make it the seventh largest in the U.S., just behind General Electric.
KKR has also become a cash machine with many ways of making money. To begin with, KKR charges investors in its buyout funds annual management fees amounting to 1.5% of their investments. Companies taken private by KKR pay the firm 1% to 2% of the purchase price for handling the transaction. But the really big money rolls in when KKR starts to sell off divisions of the companies it acquires. So far, KKR has taken in $7 billion by unloading parts of Beatrice. In recent years the investors in KKR's buyout funds have earned annual returns of about 30%. Says James George, manager of Oregon's $9 billion public-employee retirement fund, which has invested $640 million with KKR: "The secret of KKR's success is that it makes an awful lot of money for its partners." Agrees Gus Oliver, a general partner in Coniston Partners, another Manhattan investment firm that specializes in takeovers: "KKR's success reflects the compounding effect. Because of its track record, it can attract all the capital in the world. Because of its capital base, it can do any deal in the world."
Maybe, but the RJR Nabisco deal will put that assertion to a stern test. The struggle for the huge company began two weeks ago, when it was announced that a group of managers led by chief executive Ross Johnson, 56, was considering making a $17.6 billion buyout bid, to be put together by Shearson -- not KKR. The announcement came after Johnson delivered a startling message to the RJR Nabisco board of directors: "This company ought to be in play." News of the buyout proposal stunned Henry Kravis, who felt betrayed by Shearson's chairman, Peter Cohen. For one thing, Kravis and Cohen, 41, were friends and former classmates at the Columbia Business School. Moreover, Kravis had previously spoken to Johnson about a buyout of RJR Nabisco. Now it seemed to Kravis that Cohen was trying to steal the deal. Actually, Johnson had brought the idea to a trusted friend: James Robinson III, chairman of American Express and Cohen's boss.
Determined not to let the RJR Nabisco deal get away, Kravis demanded that Cohen come by KKR's Manhattan offices. Chewing out Cohen in front of Shearson aides, Kravis demanded a major role in the buyout, sputtering, "This is my franchise!" Cohen walked out, suggesting they talk again in a few days. But before that talk took place, Kravis delivered a thumping counterpunch: a $20.6 billion buyout bid for RJR Nabisco.
Once both proposals were out in the open, the two sides began to think about working together. On Tuesday, Oct. 25, Kravis and Cohen made their peace over breakfast at the Plaza Hotel. In a two-day series of round-the-clock meetings that followed, the KKR and Shearson/RJR teams discussed alternative buyout plans. George Roberts, who normally works out of KKR's offices in San Francisco, and Robinson of American Express joined Kravis, Cohen and Johnson in the negotiations.
Early on, KKR reportedly offered Shearson a $125 million "kill fee" to step aside. Cohen brushed off the idea as "personally insulting." Once serious talks began, the participants saw they had different strategies in mind. KKR preferred to sell the tobacco business to pay back the buyout loans and retain the food businesses, a good fit with the Safeway chain. Johnson's team wanted to keep the tobacco company and sell off Nabisco, Del Monte and the other non-tobacco parts of the business. Positions hardened shortly after , midnight Tuesday, when KKR partner Roberts made what may prove to be the most expensive personal gaffe in the annals of corporate negotiations.
Arriving at RJR's Manhattan offices about 1:15 a.m., Roberts flinched at the sight of Cohen puffing away on his ever present cigar and asked sarcastically if RJR, which sells some 290 billion cigarettes a year, also made cigars. Roberts, who moved to a seat across the room, seriously misjudged his audience. The last thing the embattled RJR team wanted to hear at that hour was another antismoking crack, especially from a would-be ally.
But the real sticking point was the issue of power. KKR has always insisted on controlling the companies it acquires. That policy went squarely against Shearson's promise to Johnson that he could keep 51% of the voting shares. The talks broke off on Wednesday, after Johnson said he would have nothing further to do with KKR.
At week's end KKR had the highest offer on the table, but the Shearson team was preparing a new bid. Ultimately, RJR Nabisco's board of directors, which includes such outsiders as Charles Hugel, president of Combustion Engineering and Martin Davis, chairman of Gulf & Western, will probably have the final say on who, if anyone, buys the company. Some Wall Streeters think the financing will prove so difficult that KKR and Shearson will have to work together. In a conciliatory move on Friday, KKR said it would not press for selling off the tobacco division.
If the mammoth deal is completed, it will intensify the debate about whether leveraged buyouts are good or bad for American business. Proponents point out that the stock market has severely undervalued many companies. Thus the only way shareholders can get fair value for their investment is through a buyout. Another argument in favor of the trend is that by breaking up conglomerates, buyout specialists create more efficiently run businesses.
But what is good for shareholders and investment bankers is not necessarily good for the country. Certainly the thousands of workers who have been laid off as a result of KKR's deals see little virtue in leveraged buyouts. Top executives go along with or even instigate buyouts because as major shareholders they stand to profit. The resulting companies may be leaner, but often they are also weaker, with little money to invest in expansion or innovation. Says Michel David-Weill, the French senior managing partner of the Lazard Freres investment firm: "The wave of leveraged buyouts is weakening the competitiveness of many U.S. companies that have fought so hard to regain it."
A more immediate danger is the debt being loaded on corporate America. This summer Revco, a chain of 2,000 drugstores based in Twinsburg, Ohio, defaulted on $700 million worth of bonds and went into bankruptcy proceedings just 19 months after going private in a leveraged buyout. Some experts fear that Revco will be one of many major failures resulting from the buyout binge. In the first half of this year, Standard & Poor's lowered the investment ratings for $216 billion worth of corporate securities, while raising the standing of only $130 billion in such debt. Warns economist Henry Kaufman: "If this deterioration of corporate debt is occurring in the course of an expansion, you can imagine what will happen to a lot of corporate debt in a recession."
In his letter to the Senators last week, Fed chairman Greenspan noted that current tax law encourages corporate borrowing. Companies, for example, can write off the interest on their loans. Greenspan suggested that Congress consider whether the tax incentives that are helping fuel the trend are still prudent. If Congress takes Greenspan's advice, the heyday of big-time buyouts could come to an end.
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Illustration by Mirko Ilic
CAPTION: KKR's LARGEST DEALS
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With reporting by Thomas McCarroll and Frederick Ungeheuer/New York