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Kohlberg Kravis Roberts & Co. (KKR) is one of the largest investment and merchant banking houses in the United States. It was the first to conduct, on a large scale, the leveraged buyouts (LBOs) that privatized many American corporations in the 1980s and, in the biggest LBO ever, purchased RJR Nabisco Inc. for $30.6 billion in 1989. KKR cast a lower profile in the 1990s, but its funds still had $16.4 billion to invest in early 1997--more than any other institutional sponsor of private equity funds. Besides investing on its own account, KKR was trading for such clients as insurance companies, nonprofit organizations, and state pension funds. According to one source, it realized, during its first 20 years of existence, an average annual return of 23.5 percent on its investments, compared with around 15 percent during this period for the Standard & Poor index of 500 stocks.
A Decade of Megabuck Deals: 1976-86
Jerome Kohlberg, Jr., was in charge of the corporate finance department at the Wall Street firm of Bear, Stearns & Co. when he devised or first utilized, in 1965, the technique later to be called the leveraged buyout. Kohlberg believed a company would be better managed if it were owned by a small group of highly motivated investors--often including the top company executives--rather than thousands of shareholders who rarely had the knowledge or time to make sure the business was being run effectively. To raise the money, the investors would borrow heavily&mdash much as ten times the cash they actually contributed--usually pledging as collateral the assets of the company they intended to acquire. They would reap their profit by later selling the company to new owners or issuing stock to the public.
George Roberts and his cousin Henry Kravis became proteges of Kohlberg at Bear, Stearns, although Roberts relocated to the company's San Francisco office. They conducted 14 buyouts between 1969 and 1975 with generally mediocre results in a time of recession and falling stock prices. One of the companies they bought for $27 million, Cobblers Industries, went bankrupt. However, investors in Vapor Corp., purchased in 1972 for about $37 million, recovered their stake 12-fold when the company was sold in 1978. Industrial Components Groups, a division of Rockwell International purchased in 1975, yielded 22 times the original investment in five years.
Restive at Bear, Stearns, Kohlberg persuaded Kravis and Roberts to join him in the partnership that opened its doors in 1976. KKR created an equity fund which KKR, as general partner, used to purchase companies. Adding to the pool were major lenders entitled to fixed returns and, where law permitted, sweeteners like warrants or common stock free or at bargain prices. A favorite inducement for banks was preferred stock, which offered an 85 percent tax exemption on dividends. Because of the huge debt incurred in LBOs, a prospective target had to be able to generate the high cash flow needed to make interest payments. This excluded high-technology companies with heavy research and development expenditures. The most attractive prospects were businesses like supermarket operators, provided they had little prior debt and a market niche that protected them from severe competitive pressures.
In 1977 KKR bought three companies, but investors were hard to find and the firm made no deals the next year. In 1979, however, KKR bought Houdaille Industries for about $355 million--by far the largest LBO transaction to that time and KKR's first buyout of a major publicly held company. Prior to then no LBO had been for much over $100 million. For investing $12 million of its own money, KKR received 37 percent of the voting common stock. Investors, including big banks, now began to come on board. By the fall of 1980 the firm had paid nearly $800 million to acquire seven companies with combined annual sales totaling about $1.3 billion.
Another breakthrough for KKR came in 1981, when Roberts tapped a conservative investor--Oregon's public employees' pension fund&mdashø contribute $178 million for the leveraged buyout of Fred Meyer Inc., one of the seven companies KKR acquired that year. Soon other state pension funds, looking for a better yield than what they were earning from bonds, were willing to sign on. By 1986 11 state pension funds were partners in KKR equity pools. When KKR initiated a $5.6 billion fund--its largest ever--in 1987, the 11 provided 53 percent of the money.
In addition to pension funds and other limited partners willing to provide equity (about ten percent of an LBO) and banks willing to make loans (60 percent), KKR needed subordinated lenders (30 percent), who earned a higher fixed rate by taking more risk because they were the last to get paid. Historically, insurance companies tended to be the main source of subordinated debt. By the mid-1980s, however, firms such as Drexel Burnham Lambert Inc. had assembled big money by attracting private investors to high-yield junk-bond funds which would assume the necessary risk.
For its own part, KKR collected the standard investment banking fee of around one percent for making a deal, which it usually invested in the stock of the acquired company. It also collected annual consulting fees from the acquired company. KKR partners sat on the boards of these companies and collected directors' fees. KKR also received a 1.5 percent annual management fee on the money in an equity fund not yet invested. But the real payoff for the firm was, as general partner, its 20 percent share of the capital gains from the eventual resale of the acquired company. KKR even took a fee--one percent--when it sold a company at a loss. Everybody in the firm, from the partners to the secretaries, had a stake in the rewards.
By 1983 KKR was claiming an average annual return of 63 percent to its equity partners. That year KKR's fourth equity fund accumulated $1 billion from investors, enabling its roster of companies to reach 18, acquired for a total of $3.5 billion. KKR was using this money for ever-bigger deals. In 1985 the firm acquired Storer Communications for a record $2.5 billion. When Storer was sold in 1988, KKR's partners achieved an annual return of around 50 percent. Also in 1985, KKR conducted its first hostile takeover; previously it had made an acquisition only when management (which got a stake in the deal) agreed.
KKR launched a new, $2 billion fund in 1986. The acquisition of Safeway Stores Inc. that year was the best transaction KKR ever made, according to a Fortune article that appeared ten years later. The firm paid $4.3 billion but put down only $130 million itself and reaped more than $5 billion in realized and paper profits. KKR's remaining one-third stake in the company was valued at more than $3.5 billion in early 1997. Even bigger was KKR's 1986 takeover of Beatrice Cos. for about $6.2 billion. The firm put up $402 million in equity capital, while Drexel provided $2.5 billion in junk-bond financing. According to KKR, when the final returns from this deal were realized in 1992, limited partners enjoyed an annual return of 43 percent.
The Going Gets Tougher: 1987-89
By this time, however, Kohlberg was now on his way out. After spending 1984 recovering from a serious illness, he returned to find that he was not needed or wanted by his younger partners. Kohlberg was disturbed by KKR's ever more aggressive search for deals that disturbingly echoed the tactics of corporate raiders. He vetoed so many prospective deals that he became known at KKR as "Doctor No." Kohlberg resigned in 1987 to form his own company but remained a limited partner in KKR. In 1990 Kohlberg sued his partners, alleging that they had illegally reduced his ownership stake in several buyout deals. The suit was settled under undisclosed terms.
Of the remaining founders, Kravis was the one who cast the higher profile. While Roberts, in California, avoided the limelight, "King Henry," as the media dubbed Kravis, took fashion designer Carolyne Roehm as his second wife. The couple was prominent on the social scene, contributing heavily to charities and maintaining a Manhattan duplex apartment plus homes in Colorado, Connecticut, and Long Island.
There seemed to be no limit to KKR's dominance at this time. Having raised $5.6 billion for its 1987 fund, the firm bought eight companies in the next two years for $43.9 billion, among them the over $1 billion purchases of Owens-Illinois, Duracell, and Stop & Shop. If ranked as a single industrial company, the businesses KKR controlled would have placed it among the top ten U.S. corporations. When stock prices plunged in October 1987, KKR secretly bought chunks of several top-level U.S. corporations but was unable to sell their chiefs on the LBO idea.
KKR's biggest LBO--indeed the biggest of all time--was its acquisition of RJR Nabisco, Inc. for $30.6 billion. The bidding started with a $17.5 billion offer from Shearson Lehman Hutton. Other interested parties included Merrill Lynch and Forstmann Little, neither of which charged a fee when it sold companies, an annual fee to manage them, or directors' fees for having their executives sit on the boards of the companies they controlled.
KKR topped Shearson, only to have the ante raised in turn by Forstmann Little. In what unsympathetic outsiders described as high-stakes macho posturing and a fitting end to a decade of greed, Kravis won the battle but clearly overpaid for his prize. KKR had to take 58 percent of the company itself. In 1990 it needed to pump in $1.7 billion more for a $6.9 billion recapitalization of RJR, which, after going public in 1991, lost more than $3 billion of its market value in the next two years. In 1995 KKR traded its remaining stake in RJR for ownership of Borden Inc.
KKR made other mistakes during 1987-88. Jim Walter Corp. (later Walter Industries), purchased for about $2.4 billion, later went bankrupt. Seaman Furniture Co., acquired for about $360 million, had to be restructured in 1989 to avoid bankruptcy and was in bankruptcy during 1992-93. Hillsborough Holdings Corp., purchased for $3.3 billion, went bankrupt in 1989. American Forest Products, bought from Bendix Corp. for $425 million, was sold at a loss.
Adapting and Thriving in the 1990s
After the completion of the RJR Nabisco deal in February 1989, KKR did not make another LBO acquisition for three years, not because of any loss of nerve but due to the collapse of the junk-bond market, a growing reluctance of banks to lend for this purpose, and fewer corporate raiders to put companies into play. To some degree, KKR was a victim of its own success, since companies increasingly had put their houses in order before they became vulnerable to a takeover. "Paying off debt, getting rid of divisions that are not up to snuff--companies can do that for themselves now," a University of Chicago professor told a New York Times reporter in 1995.
Without lucrative LBOs to put into effect, KKR became less attractive to partners like the state pension funds, which then began complaining about its fees. In 1989 KKR had reported an annualized rate of return of 19.5 percent, well below its average. Investors wanted higher yields to compensate for high risk and the need to keep their money tied up until there was a payoff in the form of a company sale. Bad publicity concerning fired Safeway workers riled some limited partners, especially public pension funds whose constituents included unionized workers.
One alternative KKR tried was "leveraged buildups." The firm bought a piece of Macmillan Inc. in 1989 and turned it into K-III Holdings Inc., a publishing and information-resources conglomerate that had made 52 acquisitions by 1997, when it was renamed Primedia Inc. This venture was unusual in that KKR took and continued to hold most of the equity itself. A similar transaction was KKR's 1991 injection of $283 million into Fleet/Norstar Financial Group for the purchase of the assets of the failed Bank of New England. KKR also took "toehold" minority positions in companies such as ConAgra Inc., Texaco Inc., and First Interstate Bancorp, remaining a passive investor.
KKR consoled itself and stilled its critics by taking six prior LBO acquisitions public in 1991 for a combined estimated $6 billion, which meant a sixfold return to the investors in five years, not counting the firm's own fees. In 1992 KKR purchased American Re-Insurance Co. for $1.2 billion, an LBO acquisition at $10 a share. Keeping a one-fourth stake, KKR took the company public only four months later at $31 a share. Also in 1992, the firm raised $1.8 billion for a new fund.
Even so, as the 1990s continued, disillusionment over KKR's performance became more vocal. A Fortune article claimed in 1994 that since the early 1980s the firm had barely outpaced the Standard & Poor 500 stock index, at least for its two largest investors, the Oregon and Washington state pension funds. In its 1996 annual report, Oregon's state treasury said it was disappointed with the returns on more than half of its $2.1 billion investment in KKR funds, of which $1.2 billion was in the 1987 fund. Burdened by poor-performing investments in RJR Nabisco and K-III, this fund had an average annual yield of only 12.6 percent through 1996.
As the stock market roared ahead in the mid-1990s, KKR improved its record by cashing in some more of its acquisitions. The sale of Duracell, which had gone public in 1991 as Duracell International Inc., in 1996 to Gillette Co. for stock valued at $7.9 billion brought KKR $3.7 billion for an original investment of $350 million. Between the beginning of 1995 and September 1996 it sold, for $7 billion, stock originally acquired for $1.3 billion. This included American Re for $3.3 billion and Stop & Shop for $1.8 billion. In 1996 alone the firm sold five companies for $5.3 billion.
These gains were counterbalanced by some losers. Flagstar Corp., in which the firm had invested $300 million in 1992, filed for bankruptcy in 1997. KKR put up $250 million for the $1.15 billion LBO in 1995 of the Bruno's Inc. grocery chain but wrote off the entire sum in early 1998, when the company's debt had reached about $1 billion. Spalding & Evenflo Cos., in which KKR had invested $420 million, was barely covering its interest payments in early 1998. Primedia (the former K-III) was still losing money after almost a decade because of the heavy cost of making payments on its acquisition debts.
KKR raised a record $5.7 billion for its 1996 fund. To raise this sum, the firm agreed for the first time to deduct losses from its profits and to reduce its transaction fees. Among the subscribers was the Oregon pension fund, which despite its misgivings committed to $800 million after a sales call by Roberts. For KKR the year was the firm's most lucrative ever, with Kravis and Roberts each believed to have collected $300 million. Kravis's personal fortune was estimated at more than $1 billion.
The following year was a quieter one for KKR, which was reported to be casting its eye on Europe. By early 1998, however, the firm had raised $5.8 billion for its latest equity fund. KKR had 11 partners and 14 associates at the end of 1996. Offices were in New York and Menlo Park, California.
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