DEBT FOR DEBT'S SAKE

International Financial Law Review, September 1992
By Jean M. H. Fergus

Jean M. H. Fergus of Fergus Partnership Consulting Inc., New York, reviews a recent book about KKR's role in American business in the 80s

How did 'the champs' do it? How did Jerry, Henry & George, three guys from middle America, get investors to contribute over US $60 billion to their LBO funds? How did they end up owning some of the biggest names in corporate America - Safeway Stores, Duracell, Avis, Playtex, and RJR Nabisco, owner of Oreo cookies and the Ritz cracker? How did they make so darn much money?

George Anders' Merchants of Debt, KKR and the Mortgaging of American Business (Basic Books, 1992, US$23; recently published in the UK by Jonathan at £7.99) attempts to answer such questions. Anders is a journalist who, for many years, has written about the buyout scene for the Wall Street Journal and is considered something of a specialist on the subject. Thankfully, he is able to restrain himself (for the most part) from what has become trendy moralizing on the 'excesses of the 80s'. The story of KKR, its partners and their deals makes for engrossing reading, and Anders' analysis is helpful in interpreting the phenomenon that is KKR.

Anders acknowledges that KKR's riches, achievements and successes all came from an 'idea' and, as with the best ideas, one that was common property when KKR opened its doors on May Day, 1976. The 'idea' was that companies were better off when ownership and control were united; in other words, when those who ran the company - its management- also owned the company. The idea was implemented through the leveraged buyout (LBO) mechanism, a technique which allowed a company to be purchased by a management group, in partnership with a buyout firm such as KKR and its investors, using the company's assets to finance most of the sale. With their own equity significantly leveraged with borrowed funds, current management could now play the takeover game, competing on price with outside raiders for their very own companies. The new LBO company would be run by go-getting entrepreneurs who had an equity investment to protect and, disciplined by heavy debt, an incentive to cut costs and corporate waste, thus creating corporate efficiency.

And the timing was perfect. The generation running corporate America, whose vision was framed by the Great Depression era of bankruptcies and defaults, was dying out. As Anders points out: 'That loss of fear may have been one of the most important factors in the buyout movement's rapid proliferation in the 1980s.' Old ideas about debt were being challenged. Debt was desirable and tax deductible. The new corporate leaders wanted change and equity, and the money handlers - banks, insurance companies and pension fund managers - wanted ever higher returns. The LBO provided a new corporate paradigm - with something for everyone.

But how did the partners do it? How did they get others to part with substantial amounts of money to fuel their LBO schemes? Anders' suggestion that KKR's success came in large part because of its partners' personal salesmanship skills may seem rather naive to some. However, these partners did differ from many of their brash counterparts on Wall street. According to Anders, Jerry Kohlberg, older than his partners Henry Kravis and George Roberts by nearly 20 years, positioned himself as the 'statesman in the background who could soothe the anxieties of lenders and senior executives at crucial stages'. One investor describes Kohlberg as 'a genteel, very caring person. You felt comfortable with him. His word was as good as gold.' Henry Kravis was 'gregarious and a master of small courtesies; he seemed to have spent his whole life making friends . . .' When, together, they called on one potential investor, Anders writes that 'the two dealmakers spent hours talking not just about how they did business, but about their personal values, too.' The investor recalls, 'They were big thinkers . . . What they sold was themselves.'

Another pension fund chief's assessment of George Roberts echoes these comments: 'I just instantly liked him on a personal basis. George was a tour de force. He created a calm over everyone.' Perhaps, on one level, Anders' book can be read as a primer in relationship sales techniques, or how to produce big results without using hard-sell tactics.

But beyond what may seem to be the obvious fact that people will do business with people they like, the partners at KKR had something else to offer-- an opportunity to earn an incredible return on one's investment, with what seemed to be slight risk. Done with just the right debt fulcrum, an LBO can be an hugely profitable investment for everyone. For top management, with equity set aside of between 10-15 per cent purchased at a discount, the fine tuning of operations allows the company to be brought public (usually within 5-7 years) at a significant premium. For the fund investors, as the debt is paid down from cash flow and the selling off of less profitable pieces, equity value increases. With KKR funds returning annualized profit rates of around 40 per cent, the money-men were lining up. The banks also were eager to jump on the LBO bandwagon, attracted, as Anders puts it, by 'bragging rights, fat interest income, and the chance to earn fees as large as US$20 million for organising giant loans to KKR'. And, eventually, Drexel's Mike Milken added his stunning cash raising prowess to KKR's LBO purchases, collecting substantial underwriting and advisory fees. Seldom had so much been offered to so many with so little at risk.

And KKR benefited richly as well. Their fees included an investment banking fee of one per cent of the transaction, directors' fees, advisory fees, fund management fees of 1.5 per cent of uninvested moneys, and a 20 per cent cut of any capital gains realized by the investment fund. While Anders points out that these fees were standard in the buyout business, KKR's deals were so large that their fees, in absolute terms, became gargantuan.

How did KKR come to own some of the biggest names in corporate America? The easy answer Anders offers was their ability to 'borrow more money, faster, than anyone else'. But is that all there was? The KKR story, as set out by Anders, reads like a Harvard 'B' School case study of competitive strategy at work. Getting there first, establishing a track record, narrowing their scope (initially selecting mid-sized industrial companies in niche industries), and differentiating themselves from the competition ('we only go where invited'), were key elements of the partners' early success. And KKR, by the 1980s, was the most successful and the most respected of the LBO firms. Now positioned to exploit their advantage, they did so with remarkable dispatch, and on a much grander scale.

What KKR proved was that even the biggest public corporations could be brought private. Their first deal in 1977, the buyout of A. J. Industries for US$26 million, seems puny compared to the post-1984 billion dollar deals. Among others, KKR bought out Pace Industries (1985) for US$1.3 billion; Union Texas Petroleum (1985) for US$1.6 billion; and Storer Communications (1985) for US$2.5 billion. In 1986, in back to back transactions, KKR bought Beatrice Cos. for US$6.2 billion and Safeway Stores for US$4.2 billion. Additional billion dollar acquisitions included Owens-Illinois (1987), Jim Walter (1987), Duracell (1988) and Stop & Shop (1988).

According to Anders, KKR's success was almost their undoing. The mega LBO of RJR Nabisco in 1989 cost over US$26.4 billion. For years fawned over and flattered, Kravis and Roberts found that after RJR their fortune shifted. Now squarely in the public eye, public scorn followed. The name KKR became associated with excess and arrogance. Kravis was in part undone by his 'Nouvelle Society' lifestyle. Kohlberg, now divorced from the partnership, sniped at his old firm at every available chance, criticizing his former partners' largest deals while quietly investing in them himself. Others, arguing post hoc ergo propter hoc, charged that since KKR made so much money, so fast, something must be wrong. Unions didn't like them, citing job losses, and lobbied Congress for more restrictions. And their friendly bankers were now no longer so friendly. Anders reveals that these banks got on the greed line too, adopting a 'take it or leave it’ posture in charging nearly US$200 million in fees for fresh loans to the RJR Fund.

In the book's final chapter, Anders reflects on the extent to which debt has refocused corporate America. Taking a politically correct angle, he rails against the pay cuts and job losses that were common to companies after an LBO. On the one hand, he approves of LBOs providing 'a legitimate means by which new owners could hose down such enterprises until they worked properly', while on the other, finding it 'impossible to' reconcile buyouts with the sense of fairness that is the heart of democratic capitalism'.

Anders refrains from holding KKR responsible for the US budget deficit, Mike Milken, the S&Ls, and other '80s bogeymen. However, he does hold them responsible for not having produced anything and contrasts them with billionaire industrialists Sam Walton of Wal-Mart and Bill Gates of Microsoft. Yet KKR never pretended to that role. What they offered, and still seem to be delivering, was significant return on their investors' equity. Unfortunately, what Anders fails to do is test the validity of the original 'idea': Were LBO companies more efficient and thus better off, or have they, like liquid crash diets, produced short term results without long term benefits? Although Anders takes us on an informative journey through the KKR deals, he fails in the end to address this 'overwhelming question'. While not expecting axiomatic answers, those readers looking to place KKR in a broader business context may be left unsatisfied.


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