By executing its first leveraged buyouts, Kohlberg Kravis Roberts ushered in an era of debt-financed acquisitions that enabled many businesses to remain viable but led to the use of risky securities.
In early 1977, Kohlberg Kravis Roberts (KKR), a newly formed investment banking firm, acquired three small firms, A. J. Industries, U.S. Natural Resources, and L. B. Foster. Although these transactions were comparatively small in size, they were important as the first leveraged buyouts (LBOs) executed by a specialized investment banking firm.
KKR was designed as a different type of investment banking firm, a “boutique” whose only service was LBOs. The principals—Jerome Kohlberg, Jr., Henry R. Kravis, and George R. Roberts—had worked together at Bear Stearns, a leading full-service Wall Street investment banker. While at Bear Stearns, Kohlberg had learned to execute financing packages known at the time as “bootstraps.” In essence, a bootstrap raised cash based on a firm’s assets and its ability to service the debt taken on as part of the transaction. Through this process—some called it “financial engineering”
In 1965, Kohlberg arranged his first bootstrap at Bear Stearns, a $13.8 million transaction involving a producer of precious metals, I. Stern. This arrangement was eminently successful, ultimately providing management and investors with a return nearly eight times the original investment. Kohlberg followed up on this first success by arranging three more bootstraps in 1966. In 1969, he did another, this time assisted by two young investment bankers, Kravis and Roberts, who would become his partners.
In 1972, the trio pulled off another such transaction, which because of its extensive use of debt had by this time become commonly known as a leveraged buyout. This LBO of a major Singer Corporation subsidiary represented a milestone in that it transformed a subsidiary of a publicly traded corporation into a private company.
As Kohlberg and his young associates continued to execute more transactions into the mid-1970’s, they recognized that they had uncovered a major market opportunity. The conglomerate craze of the 1960’s had resulted in numerous smaller companies being acquired by major corporations without much concern as to markets or other synergisms. During the 1970’s, many of these conglomerates took the advice of consultants who recommended that they divest these “underperforming” divisions about whose businesses they knew little. The trio also recognized that through their innovative LBOs, they were producing far more income than were other Bear Stearns partners. This fact began to grate on them, especially since they were considered mavericks by many within the staid firm. Kohlberg developed a plan for setting up a separate business, which Kravis and Roberts elected to join.
On May 1, 1976, Kohlberg Kravis Roberts officially opened for business in New York City. Other than an interest in LBOs and tennis, the new partners had little in common. Although all three were of Jewish heritage, only Kohlberg had any significant religious background. His personal and ethical values came largely from his college experience at Swarthmore College, an institution associated with the Quakers. Kohlberg came to value the principles of tolerance and selflessness espoused by Quakerism that he had not found through his own religion. In contrast, Kravis and Roberts had attended more secular colleges that did not provide this type of experience.
At first, this disparity of values did not hamper the young organization. All three recognized that they were now on their own and needed to execute a few modest deals to become a viable firm. They agreed to start at annual salaries of $50,000 each, modest by New York financial standards in the 1970’s.
Although the young firm had little difficulty identifying solid companies worthy of purchase, obtaining financing was a significant challenge. The concept of a leveraged buyout was still new, and the investment returns the partners claimed to have earned while at Bear Stearns seemed too good to be true. Insurance firms and banks were especially difficult to convince, but after several months of trying, Kohlberg’s quiet demeanor and years of experience began to convince the skeptics.
It was with this background that KKR executed its first transactions in early 1977. The immediate effect was of only moderate significance, but the longer-term impact and the implications were much more dramatic, setting the stage for an entirely new financial era in the 1980’s.
Although the KKR partners recognized the value of what they had initiated, the financial world was not yet ready to follow. During its second year, KKR executed no buyouts. Skeptics continued to dispute the concept that a buyout improved management’s motivation to perform.
In mid-1978, Kohlberg’s low-key approach began to bear larger fruit. Goldman Sachs, a major investment banker, put KKR in touch with Jerry Saltarelli,
By this time, KKR had established a set of principles it believed were conditions for a successful buyout. The company needed a long-established, predictable cash flow, clearly sufficient to service the debt produced by the LBO. Better candidates had usable, fully depreciated fixed assets that would cost significantly more to replace than they had cost to purchase. The best candidates operated in mature markets, in which technological upheavals were unlikely, and were relatively free of debt prior to buyout. Finally, the company needed a strong management team, all or most of whom would stay on to maintain continuity. Houdaille appeared to fit all these conditions.
In October, 1978, Houdaille and KKR went public with their plans to form an investor group to purchase all of Houdaille’s shares at more than double the current market price. This was clearly a “make or break” deal for KKR, because a publicly traded firm had never gone private through a leveraged deal. Much of Wall Street was skeptical, with the result that Houdaille stock traded well below the offer price into early 1979. Only when Houdaille announced consummation of the $335 million deal did the market fully respond.
KKR’s success amazed veteran Wall Street observers. The final deal incorporated a staggering array of legal instruments and participants, which included three banks, a major insurance company, and Oregon’s state pension fund.
Following the coup in buying out Houdaille, KKR became an accepted “niche” investment banking firm. In 1983 alone, it purchased three more companies and initiated efforts to raise a $1 billion equity fund. As KKR successes continued, however, both internal and external problems arose. Externally, many Wall Street firms had come to accept the leveraged buyout concept, and, by 1985, many of them had established their own LBO departments. This move placed these new departments in direct competition with KKR.
Internally, the philosophical and ethical differences between Kohlberg and his younger partners began to emerge. KKR’s original concept was that the partners should reap profits only when the other investors and management of bought-out companies did. In early 1984, Kohlberg had serious surgery and was absent from the firm for nearly a year. During this hiatus, Kravis and Roberts began to change the original philosophy so that KKR would make money regardless of how management and investors fared.
The combination of a more aggressive business philosophy and increased competition dramatically changed the LBO business. KKR found that it could now close transactions only by outbidding two or three rivals. This forced KKR to establish alliances with other investment banking firms to raise needed capital. A key alliance struck by KKR was with Drexel Burnham Lambert,
In 1985, KKR offered to buy Storer Communications for $2 billion in the largest leveraged deal proposed at that time. When Comcast Corporation also made an offer for Storer, Michael Milken, a bond trader with Drexel, induced Ivan Boesky
Clearly, KKR had gotten far away from its original values to execute deals. This change enraged Kohlberg, who, by the time he returned full-time in early 1985, found himself powerless to reverse the new philosophy his younger partners had driven into KKR. In an emotional 1987 speech at KKR’s annual investment conference, Kohlberg announced his resignation from the firm he had created. He formed a new firm, Kohlberg and Company.
Kohlberg’s resignation had little impact on Kravis and Roberts. Although furious with Milken over the secretive Storer chicanery, KKR continued to use Drexel as additional opportunities arose. The most significant was the largest LBO ever transacted, the RJR Nabisco buyout in 1988. That transaction was valued at $29.6 billion.
By the end of the 1980’s, KKR had acquired thirty-six companies at a cost of $85 billion. Although the volume of LBOs decreased in the early 1990’s, the technique remained a viable option for many firms, especially for deals that could be executed without resort to high-interest “junk” bonds.
KKR itself continued as an extremely powerful enterprise. Its impact on U.S. financial history has been immense. As this fledgling firm convinced the rest of the Wall Street community of the viability of the LBO concept, it ushered in a new era. The original concept of LBOs was excellent. The idea that managements perform better when they are part-owners seems obvious in retrospect. When KKR and other LBO specialists deviated from their basic principles, however, they produced side effects, such as the Milken improprieties and indictment, that even the most ardent KKR executive would not defend.
From an overall societal standpoint, the LBO boom of the 1980’s produced the most extensive indebtedness in corporate history. Some analysts believe that LBOs were to a significant extent responsible for the severe stock market sell-off in October, 1987. Most conservative CEOs argue vociferously against the impact of LBOs, but not all observers agree that LBOs had negative effects on balance. Some writers contend that since indebtedness was limited to stable firms, the more cyclical firms that stayed away from LBOs actually became stronger. They argue that every postwar expansion has resulted in huge amounts of debt, so the 1980’s were not an exception to be explained by LBOs. Others point out that LBOs enabled a number of large firms, Safeway being a major example, to survive, thus saving jobs.
The early portion of the 1990’s provided a mixed business environment. Some sectors, such as the automobile industry, made major strides, while others stagnated. The debt binge of the 1980’s had clearly abated, and “reverse LBOs” surfaced in several industries. At the same time, the LBO continued to be an important financing vehicle, enjoying upsurges in the mid-1990’s and in 2004, along with the more recent related innovation, the leveraged buildup strategy.
-
Bartlett, Sarah. The Money Machine: How KKR Manufactured Power and Profits. New York: Warner Books, 1991. This comprehensive volume represents the most thorough evaluation of KKR’s legacy. Chapters most relevant to key issues include “Jerry” and “Early Days.” The book is generally favorable to Jerome Kohlberg and his ethical values but generally unfavorable to Henry Kravis. The discussion of Kohlberg’s early exposure to the values of Quakerism are particularly illustrative. -
Faltermayer, Edmund. “The Deal Decade: Verdict on the ’80’s.” Fortune, August 26, 1991, 58-70. Comments negatively on the LBO boom. Cites the decline in corporate cash flow following most transactions and argues that takeover threats siphoned valuable time away from corporate management. Includes excellent graphics and statistical analysis. -
Fisher, Anne B. “Don’t Be Afraid of the Big Bad Debt.” Fortune, April 22, 1991, 121-128. Argues that the LBO boom of the 1980’s did not permanently damage the nation’s competitive stature. Points out that every prolonged postwar expansion has produced huge debt on corporate balance sheets. -
_______. “Employees Left Holding the Bag.” Fortune, May 20, 1991, 83-92. Describes the human impact of leveraged buyouts, with particular regard to buyouts in which workers became owners. Cites a number of examples of failure that resulted in numerous employee-owners losing their jobs. Deals mostly with employee stock ownership plans (ESOPs). -
Gibson, Stuart. Creating Value Through Corporate Restructuring: Case Studies in Bankruptcies, Buyouts, and Breakups. New York: John Wiley & Sons, 2001. Using thirteen case studies, the author explores many levels of corporate restructuring and its effects. Geared toward students of business. -
Holland, Max. “Buyout (1979-1980).” In When the Machine Stopped: A Cautionary Tale from Industrial America. Boston: Harvard Business School Press, 1989. Chapter in a book focusing on the history of Burg Tool describes in detail the buyout of Burg’s corporate parent, Houdaille, through the efforts of KKR. Also discusses much of the background to KKR’s establishment as an LBO specialist. -
Morgenson, Gretchen. “The Buyout That Saved Safeway.” Forbes, November 12, 1990, 88-92. Describes some of the positive impacts of leveraged buyouts. Focuses on the 1986 LBO engineered by Kohlberg Kravis Roberts that literally saved thousands of jobs. Comments favorably on KKR. -
Van Horne, James C. “Corporate Restructuring.” In Financial Management and Policy. 9th ed. Englewood Cliffs, N.J.: Prentice Hall, 1992. Discusses, in syntax designed for sophomore or junior college students, the concept of the leveraged buyout and its positive and negative impacts. Also of value to readers, including businesspeople, who wish to see how academia treats the LBO issue.
Insider Trading Scandals Mar the Emerging Junk Bond Market
Drexel and Michael Milken Are Charged with Insider Trading