Notes on Leveraged Buyouts
Feb 12, 2023
I've found the massive leveraged buyouts of the 1980's to be really interesting lately, especially since my cohort (young millennials working in tech) is experiencing our first major buyout of a company we're very familiar with, Twitter.
I read Merchants of Debt by George Anders, which focuses on the investment firm KKR, and Barbarians at the Gate by Bryan Burrough and John Heylar, which focuses one one deal, RJR Nabisco.
Note that there will be spoilers on the RJR Nabisco deal, so read Barbarians at the Gate first if you don't want to know what happened.
Before we go into how the 1980's deals relate to modern day, let's go over how one firm, KKR, did some of the largest and most profitable takeovers in Wall Street history.
Jerome Kohlberg, his mentee Henry Kravis, and Kravis' cousin George Roberts started KKR (Kohlberg Kravis Roberts) in 1976. Kohlberg later left in 1987 due to tensions within the partnership.
Their focus in the 1980's was acquiring private or public companies in leveraged buyouts, which means a large portion of the funds would be raised from banks or other investors. In 1989, they bid for and successfully acquired RJR Nabisco, a tobacco and food company, in the largest buyout ever at the time.
After their RJR Nabisco deal, the booming economy started to slow and KKR's era of massive buyouts was over. They managed to save companies in their portfolio enough to stay afloat, and their new business became taking companies public.
A Ripe Environment for Leveraged Buyouts
KKR's success may have been partly a product of its time because there were many tailwinds that encouraged the wave of leveraged buyouts in the 1980s.
Strong macro environment
The US was in a bull market from 1982 to 1990.
Before this period, debt was often seen as a negative on a company's balance sheet, but once the economy was strong, sentiments shifted, and taking on debt became more palatable to operators and lenders.
A strong economy also meant a lot of growth, so acquirers and their lenders could be confident that promising companies would increase in value in the future.
Deductibility of interest
Deducting interest meant that acquirers could use more debt to fund their bids, without increasing future tax bills too much. This made takeovers a better deal.
Personal computers allowed bankers to do more analysis on takeover targets quicker, with a smaller team.
KKR negotiated for RJR Nabisco, a massive takeover of $26.4 billion, in only 6 weeks.
How KKR did business
KKR had great timing, but also did a lot of things right to produce impressive returns in a short period of time.
KKR did a lot of outbound prospecting in the early days, led primarily by Kravis and Roberts. They sought out strong cash flow businesses across the country and pitched the owners on selling the majority of their company to KKR, which KKR would fund with borrowed money. They told owners they could make five times their money in five years.
They faced many rejections from owners who didn't want to sell, but persisted and did increasingly larger deals.
On one of its early deals, KKR quite boldly negotiated a $1 million fee for serving as an investment bank in a buyout, even though they were also the buyer. This became a massive source of additional revenue by setting a precedent for the firm to take larger cuts on deals in the future, up to $75 million in the RJR Nabisco takeover.
Managing public image
KKR's style was to create friends, not enemies.
The firm was not stingy- the accounting, legal, and investment firms they worked with enjoyed large fees for working on KKR's deals. They focused on building a network of allies, and gave their work a positive spin to the public by saying leveraged buyouts make the American economy more efficient.
Effective sales styles
To keep its buyout machine running, KKR had to convince executives and the board to sell their company, and banks and outside investors to give them the money to do it.
Kravis honed his pitch to operators by doing outbound in the early days of KKR, and told them they could make a lot of money and look good at the same time.
Roberts did a great job at rounding up lenders and investors. He framed it as giving them an opportunity, rather than asking for money.
Raising cash quickly with junk bonds
KKR used junk bonds to raise more money quickly, and outsourced the selling of these bonds to an underwriting firm with questionable practices, called Drexel.
Turning over businesses quickly
The firm wasn’t sentimental about any of its businesses. They had bold cost-cutting strategies, executed layoffs, and broke up and sold off companies to achieve a high rate of return in a short period of time.
Selling companies quickly also freed them up to pursue new buyout opportunities, instead of managing an ever-growing portfolio.
After acquiring a company, KKR had a playbook of tactics they would use to save money and meet debt obligations. This included adjusting the depreciation of assets to garner a lower tax bill once the acquisition went through, negotiating hard with unions, doing layoffs, cutting unprofitable divisions, selling promising divisions if they could get a good price, and creating new compensation plans.
Often, KKR would sell the top ~50 executives additional shares in the company, and would encourage them to put a lot of their money in. This highly motivated management.
The downfall of KKR's leveraged buyouts business
The good times wouldn't last forever at KKR. In the late 1980's, public sentiment turned against their business, and the bull market ended.
Shifting macro environment
The economy slowing changed the game for KKR, and exposed that their strategy was very vulnerable in anything other than a bull market. The cash flow at their portfolio companies suffered, and KKR had to often put more money in, alongside their external investors.
The assumption that the acquisition targets' values are likely to go up in the future, a key part of the firm's pitch, suffered.
The drying up of the junk bond market
When the macro environment changed, the junk bond market evaporated. Investors didn't want to buy bonds that were defaulting at a high rate.
This affected how easily KKR could raise cash.
Bad PR of RJR Nabisco
The RJR Nabisco deal was perhaps a turning point for KKR's public image. It was very public in the press, with everyone looking bad: Kravis, Ross Johnson (RJR's CEO, who had started the bidding war), and even the RJR board.
Kravis especially was painted as a corporate raider, and the media had the visuals of him posing in front of luxurious belongings like $1 million dollar paintings. He seemed the picture of greed.
Ross Johnson's massive post-acquisition compensation plan was leaked, which also made him look greedy, and his attempts to cover it up made him look untrustworthy as well.
The board had collected large bonuses from Johnson prior to the buyout negotiations, so their impartialness was called into question.
The result of this bad PR on KKR's future business was significant.
It became harder to sell the idea of a leveraged buyout to management of large companies, because they didn’t want the same kind of negative press. Many of KKR’s former allies started to distance themselves. Buyers who would previously interested in bonds linked to KKR companies didn't want them anymore.
New laws made it harder for KKR to depreciate assets post-acquisition, and to avoid taxes by creating mirror subsidiaries for divestitures.
Previously, KKR would create mirror subsidiaries that housed the assets to be sold off, and funneled the proceeds to the parent company as a dividend, thus deferring the taxes.
The business judgement of boards
In another buyout that didn't involve KKR, a Delaware court defended a board taking a lower bid offer by saying that that’s within their business judgement to take an offer that is not higher, if it’s more in the long-term interest of their shareholders.
KKR was often accused of favouring short-term growth over long-term, so this would affect their ability to win a deal.
Mistakes KKR made
Many of the factors that caused KKR's buyout business to collapse couldn't be avoided, but some mistakes were still made.
They were overleveraged
Clearly, the firm had taken on bets that were too large and Kravis even admitted that they put too much of their buyout fund into acquiring RJR Nabisco. A more conservative strategy would have made for a softer landing when the economy turned.
Firm was too small to effectively manage portfolio
The firm was very small, so it was difficult to manage companies in the portfolio on a detailed level. Employees felt alienated from management, which increased resentment.
Underestimated bad PR of layoffs and wage cuts
KKR didn’t manage the PR of layoffs and wage cuts very well. As a result, powerful stories of personally impacted employees came out that caught the public’s attention, and it was all traced back to KKR.
KKR's business: good or bad?
KKR was laser focused on ROI (return on investment) over a short time horizon. Its short-term flipping of companies did not often leave companies in a better long-term position after KKR sold them.
After KKR's acquisition of Safeway, they cut underperforming stores, and sold off highly profitable ones if they could get a good price. Some of the underperforming stores could have grown over time, but KKR didn't want to invest the time. The highly profitable stores were good long-term assets, but KKR could make more money by selling them off, and then later selling the whole company.
Their tactics focused too much on increasing efficiency at the expense of setting up businesses for future growth.
Tech buyouts today
Buyouts of large companies are healthy for the market, as long as the acquirer intends to strengthen the company for the long term.
Elon’s takeover of Twitter, while rocky and controversial, was done in earnest because the buyer is heavily and thoughtfully involved in the management of the company and is not just trying to flip the company for short-term profit.
The Twitter buyout shattered the illusion that a big tech company can't be taken over.
I think this is a good thing.
I would love to see a group of engineering leaders execute a leveraged buyout of a large tech company with a bold long-term growth strategy.