Thayer Watkins

Summary of Merchants of Death: KKR and the Mortgaging of American Business by George Anders

Some attribute the invention of the leveraged buyout to Kohlberg, Kravis, Roberts or Jerry Kohlberg in particular, but George Anders notes that leveraged buyouts occured before Kohlberg began arranging them while working at the brokerage firm of Bear, Stearns. Although the invention of leveraged buyouts (LBOs) cannot be assigned to KKR it is fair to say that KKR perfected the LBO.

At Bear, Stearns Jerry Kohlberg began arranging the financing of friendly takeovers of small firms. Sometimes the founder of a business or the founder's heirs wanted to sell their equity. The management of the business were more knowlegeable than any other potential buyers of the value of the business. But the managers often did not have the financial wherewithal to buy the business. Kohlberg would find lenders who would provide the bulk of the capital for the purchase of the business in return for an appropriate interest rate on the debt and perhaps a share of the equity. Bear, Stearns, for whom Kohlberg worked, would get substantial fees for handling the paperwork and the legal details. Kohlberg limited his work to arranging friendly takeovers and was known for his integrity.

George Roberts joined Jerry Kohlberg at Bear, Stearns in the late 1960s. He had worked for Bear, Stearns first as a student while he was finishing his college work. Roberts was twenty years younger than Kohlberg. Later a cousin of Roberts, Henry Kravis joined Kohlberg and Roberts at Bear, Stearns. Kravis, the son of a well-respected petroleum engineer, grew up in Tulsa, Oklahoma; Roberts, the son of a Houston oil broker, grew up in Texas. Despite the distance between their homes Kravis and Roberts were close as cousins and spent a good deal of time together as children. They were close enough in physical appearance for people to think they were brothers rather than cousins.

Kravis was also much younger than Kohlberg and more aggressive. At first there was a problem of personality differences between Kohlberg and Kravis but Kravis adapted himself and he and Roberts formed an effective and efficient with Kohlberg. When Kohlberg decided to leave Bear, Stearns in 1976 he asked Roberts and Kravis to join him in forming their own firm.

It was an inauspicious beginning based upon $120,000 of capital contributed by the partners. There was a Manhattan office, out of which Kohlberg and Kravis operated, and a San Francisco office where Roberts worked.

Houdaille Industries

$355 million ROE = 22%

Houdaille (how DYE) Industries of Fort Lauderdale, Florida was founded in 1925 by a French immigrant. By the 1970s Houdaille, a conglomerate corporation ranked among the Fortune 500, was producing automobile bumpers, machine tools, steel and a variety of other products. It employed 7700 and had annual sales in the $400 million range. It was managed very conservatively by Gerald Saltarelli, who as a result of seeing the trauma of debt foreclosures during the Great Depression studiously avoided the use of debt in financing Houdaille's operations. Houdaille did have $22 million of debt, but it was only 15% of total capital and it had cash reserves of $40 million.

The leveraged buyout is based upon the tax advantage of debt and the power of leverage. Therefore Houdaille was a prime candidate for an LBO. which would increase the market value of the company by increasing it use of debt. Houdaille had aftertax profits of $28.5 million but pretax profits of $50.8 million. The interest on debt is tax deductible and thus a major share of the interest that would have to be paid after an LBO would be paid out of the $22 million Houdaille was paying in profit taxes.

Although the unutilized debt potential was obvious, Houdaille went on the market actually because a family in Buffalo, N.Y. was trying to acquire control through stock purchase. Houdaille's chairman, Saltarelli, asked the brokerage firm of Goldman, Sachs to him prevent a takeover. But Goldman, Sachs stood to win a $3 million fee if they could arrange a sale. Thus KKR was brought in as a buyer which would prevent the takeover by the family from Buffalo.

In 1978 Houdaille stock was selling for about $25 per share, but KKR's analysis indicated that they could offer $40 per share in an LBO. This would require raising about $355 million for the buyout. About $300 million would come from debt capital, about $25 million from come from equity capital supplied by the KKR and its partners and Houdaille management, with the rest being raised by the sale of preferred stock to banks. The amount of capital that came from KKR people was only $1 million.

KKR created four classes of debt for the lenders to choose from:

  • Senior debt, which would be attractive to banks
  • Three classes of subordinated debt, with different interest rates, degrees of security and equity participation

Continental Illinois, a major bank, was the first to offer funds ($30 million), thanks to the efforts of an eager-beaver loan officer of Continental Illinois, Michael Tokarz. Tokarz later joined KKR as an associate. The Prudential Insurance Company was another institution to make an early pledge of funds ($107 million). Bankers Trust lend funds itself and organized syndicates of lenders to KKR.

A important element of KKR's strategy for handling the finances of Houdaille was Tom Hudson, an accountant and head of the Greensboro, North Carolina office of Deloitte, Haskin & Sells. Hudson had developed an alternate approach to computing depreciation which would drastically reduce Houdaille's tax bill. The use of Hudson's procedure required the creation of several shell companies. Although these shell companies were merely legal phantoms they had to go through the formalities as though they were real companies. Henry Kravis served as an officer for several of these shell companies and ended up writing himself letters to fulfill the various legal transactions.

The acquisition was completed in 1979. This was a bad time for a leveraged buyout because interest costs rose sharply soon after because of the monetary policy of the Federal Reserve under Paul Volcker. Houdaille weathered the problems. Later Houdaille was sold off by KKR and still later reacquired and renamed the Idex Corporation.

Safeway Stores

$4.2 billion ROE = ?

The Safeway chain of supermarkets was created by the Magowan family, and successive generations of the family were quite proud of Safeway being the largest (in terms of sales) supermarket chain in America. What the general public did not know was that Safeway was achieving sales in some cases at the expense of profits. Safeway was operating at a loss in states like Kansas and Oklahoma. The profits in California were subsidizing the losses in other states. A major reason for the losses in places like Kansas was that the wage scales were set at levels appropriate for California. But in places like Kansas Safeway was confronting competition that were paying wages appropriate to their labor market. Safeway had to match the product prices of their competition in Kansas but had to pay California-level wages. Jobs at Safeway in Kansas were a good deal for those lucky employees and those lucky employees were undoubtably dedicated, loyal employees of Safeway. But the subsidizing of the losses was an artifical condition that could not go on forever.

Corporate raiders perceived that Safeway was not operating up to its profit potential. In 1986 when Herbert and Robert Haft started acquiring Safeway stock the Safeway management under Peter Magowan began to look for a "white knight" as an alternative. Although later KKR came to consider a sinister element in the market, in 1986 KKR was still considered a "white knight." Henry Kravis and George Roberts were polite, considerate and charming while the Hafts were considered abrasive and abusive.

RJR Nabisco Inc.

$26.4 billion ROE = ?

RJR derives from R.J. Reynolds Tobacco Co. and Nabisco is a cropped version of the National Biscuit Company.

Beatrice Foods

Although Beatrice Foods was not a familiar company to the general public its brands were familiar; e.g., Tropicana juices.

Drexel Burnham Lambert

Drexel Burnham Lambert was formed by the acquisition of the older, conservative brokerage firm of Drexel by the newer, more aggressive firm of Burnham. Michael Milken went to work for Drexel and stayed on after the acquisition. Milken had single-handedly developed a division at Drexel which specialized in high risk-high yield securities, popularly known at junk bonds. Under Milken direction Drexel came to dominate the the multibillion dollar market for junk bonds.

Milken's junk bond operations were key elements in the leveraged buyouts that KKR put together. In the late 1980's Milken and his chief lieutenant, Peter Ackerman were involved in 13 of KKR's major deals.

KKR had found that the most diffult component of the financing of one of their LBO's was the subordinated debt. Some debt is senior and its holders are first in line to be paid. Only after the senior debt holders are paid can any of the company's funds be paid to the subordinated debt holders.

In a typical KKR LBO, KKR and its associate investors would contribute 5 to 20 percent of the purchase price. The senior loans from banks would amount to no more than 60 percent of the purchase price so that left from about 20 to 40 percent of the purchase price to be raised from subordinated debt. Initially KKR went to insurance companies such as Prudential to market the subordinated debt, but the insurance companies started demanding better and better terms (higher interest on the debt and a higher share of ownership of the acquired companies). Peter Ackerman of Milken's division of Drexel called KKR first in 1981 with an offer to help with their financing. When KKR discovered the ability of Drexel Burnham Lambert to raise enormous amounts it relieved KKR of the difficulty of dealing with insurance companies.

KKR's first involvement with Drexel went amazingly well. KKR was seeking $100 million and expected that there would be a week or two of negotiation before the deal could be closed. Instead KKR found that they only had to make a presentation to some Drexel's clients such as Fred Carr of First Executive Insurance and Tom Spiegel of Columbia S&L. Carr and Spiegel liked the bond offering and agreed to buy them. That was all it took. Drexel charged substantial fees, $3 million in the case of the $100 million, but it was worth the cost to KKR.

Drexel's tremendous financial clout was crucial to KKR. Storer Communications, an operator of television stations and cable-TV networks, was being pursued by corporate raiders. The management, under Peter Storer, sought an alternative. KKR was encouraged to bid. In bidding to buy Storer Communications KKR had borrowed all it could, including a $1.2 billion junk bond issue marketed by Drexel, to put together a $2.5 billion offer. But KKR's offer included $255 million of preferred stock that the shareholders would have to take as part of the purchase price. The board of directors of Storer objected to the preferred stock and KKR at the last minute had to come up with $255 million in cash. George Roberts visited Drexel and Milken quickly agreed to purchase the $255 miilion of preferred stock. KKR won the bidding for Storer thanks to the quick help of Milken. Drexel received $55 million in underwriting and advising fees, but KKR was quite willing to pay such fees in return for such effective help.

Occasionally the fee Milken and his asssociates got was more than KKR realized. In order to market the junk bonds for the Beatrice Foods buyout Drexel claimed it needed to offer equity participation to the bond buyers in the form of warrants. Drexel began marketing the Beatrice bonds without the warrants, holding them in reserve in case they were needed to sell out the issue. When the bonds sold out without the warrant Milken and people in his group bought the warrants themselves at a price below their market value. When the people at KKR found out what happened to the warrants there was some outrage, but not enough to seriously threatened the relationship with Drexel at that time.

Ultimately KKR did end the relationship with Drexel and by the time that Drexel and Milken were indicted for security violations KKR was not a Drexel customer.

KKR clearly benefited tremendously from the junk bond mania of the 1980s. Buyers poured $18 billion into the junk bond market from 1986 through 1988. However weaker and weaker bond offerings were being underwritten. Interest coverage,the ratio of operating earnings to interest payments, is one measure of the riskiness of debt financing. Before the junk bond era a ratio of 6 to 1 was considered normal. At the beginning of the junk bond era a ratio in range of 2 to 1 was considered risky. Near the end the market was buying bonds of firms with interest coverage ratios in the range of 0.75. This means the firm could not possible meet its debt payments out of earnings. The ratio of cash flow, which includes depreciation allowances as well as current earnings, to interest payments was in range of 1.25 to 1. The junk bond offerings began to rely upon interest payments in bonds rather than cash. This is just a disguised way of deferring interest payments. Ultimately, the junk bond market collapsed and investors realized that often the higher interest rates were not enough considering the higher risk the junk bonds entailed. The bonds issued in KKR LBOs generally performed much better than the junk bond market in general.