By: George Baker
The title of this one intrigued me. I remember hearing about KKR buying Nabisco. The buyout occurred in 1988 but the effects were felt over the next decade with several of my friends’ parents being affected.
Much of what I do professionally involves matching the right financial structure with the right incentives of stakeholders (from investors to the onsite staff).
This book is concerned with a semi-recent financial innovation: the leveraged buyout.
The Leveraged Buyout (LBO):
The leveraged buyout was a classic entrepreneurial coup: its economic impact was great; its practitioners were revered and feared.
Among the so-called “LBO firms” Kohlberg Kravis Roberts (KKR) became the most successful, and the most notorious. Its organizational life began in 1976, when a restless trio of dealmakers left the investment bank Bear, Stearns, Inc., to found their own partnership.
Jerome Kohlberg, Henry Kravis, and George Roberts opened two small offices in New York and San Francisco, from which they solicited funds from banks and individual investors, many of whom were familiar with their well-honed technique for buying small companies with debt.
LBO Methods Explained:
KKR would buy well-established, privately controlled companies with predictable streams of revenue and cash flow. In financing their acquisitions, they borrowed nearly all of the money. By employing high levels of debt, or leverage, they minimized the cost of buying the equity, which they shared with the target companies’ managers. Assuming that the cash flows of the acquired businesses would be more than sufficient to repay the borrowing, their success depended on a combination of timely debt reduction and the promotion of longer-term efficiency. If all went well (typically within five to seven year), they resold the leveraged equity for substantially higher-than-average gains.
As operations increased in scale and complexity, large corporations became increasingly dependent on a new kind of executive: the professional technocrat.
In modern, complex corporations, managers typically became executives because of their strategic talents, technical expertise, and organizational experience rather than their familial ties or ownership stakes.
Even so, the doctrine that enterprise existed primarily for the purpose of creating wealth for shareholders remained the best discipline. Creating a valuable company requires making a healthy company. The results of this discipline were: maintaining profit margins while growing sales. This allows a company to benefit customers with improvements/innovation, benefit employees (cash to pay personnel and create additional jobs), and benefit owners (healthy return on invested capital). Win, win, win.
KKR came of age in the fourth merger and acquisition wave, which began just as the U.S. emerged from the recession of 1981-82.
Assembled by its accounting firm, Deloitte, Haskins & Sells, KKR’s data showed that its buyouts had resulted not only in substantial increased in the market values of companies and potentially higher tax revenues, but also in generally increased employment, capital investment, and R&D expenditures of assets that remained under KKR’s control.
The key to high equity returns was the recognition that company growth was not necessary to value creation. The leveraged financing allowed reforms in management – sometimes radical, sometimes no more than mundane operational “blocking and tackling” – to be converted into capital gains.
To see how this works in general terms, imagine a company is bought for $100 million. Before the acquisition, this company generated $10 million in cash flows, just enough to give shareholders a 10 percent return.
The acquisition is financed with $90 million in debt and $10 million in equity.
The company is then able, through improved operations, superior asset utilization, and careful capital investment, to increase cash flows from $10 to $20 million per year, without either increasing or decreasing the value of the assets.
By paying no dividends, and by using this $20 million in cash flow strictly for debt service, this company can pay down the $90 million of debt (at an interest rate of 10 percent) in about 6 years.
At the end of that period the company would still be worth $100 million, but it would now be all equity. In other words, the original $10 million equity investment has been transformed into one worth $100 million, for a 47 percent compound annual rate of return.
Partnership with Management
There were new rules to the game following a management buyout, regarding both control systems (performance measurement and rewards) and the governance structure of the business (that is, the allocation of decision rights).
Executive managers, like investors, had to learn to focus on unfamiliar measures, such as return on market value and free cash flow, instead of earnings per share, earnings growth, and price-earnings ratios.
The evolution of the KKR board dates from the Bear, Stearns buyouts of the early 1970s, when the three original partners gained experience not only in structuring buyouts but also in post acquisition restructuring, taking companies public, and finding buyers for disposable assets.
KKR saw to it that managers were managing every day to make major changes, the incremental improvements, and the investments necessary to maximize longer-term shareholder value.
As the stock price moved up, KKR gradually sold off shares, while managers increased their personal holdings and broadened employee ownership as well.
Collaboration was the essence. Every time they hired new personnel, KKR’s partners looked for people who seemed collegial in temperament. Once hired, new KKR professionals were then tied to a financial incentive system that would encourage their cooperative instincts to flourish.
In its basic outline, the system was simple. The firm provided two ways for professionals to earn compensation beyond their salaries. One was through ownership of stock in the firm’s portfolio companies. In addition, after 12 to 18 months, the associate would be granted a fixed percentage in the firm’s bonus pool. The bonus pool roughly equaled the firm’s profits for the year: it included all the firm’s fee income (deal fees, management fees, and retainers), plus 20% of the capital gains on each investment (the “override”), net of operating expenses for the year.
The firm’s profit sharing did not end with the investment professionals. All support personnel, including the firm’s secretaries, receptionists, kitchen and mail room staff – indeed everyone employed by the firm – were given “phantom shares” in the firm’s deals.
Management buyouts breathed new life into financial capitalism, which in turn stimulated a new era of sustained economic growth, vibrant securities markets, and nearly full levels of employment.
Once scorned as a dangerous form of paper capitalism, it demonstrated the beneficial effects of linking managerial and ownership interests in the common pursuit of value.
The KKR LBO Formula
- Buy existing businesses using debt.
- Restructure the business to give ownership/profit sharing to employees.
- Incentivize financially to grow and operate a healthy business.
- Apply principles and lessons learned from other businesses.
- Exit the business by selling shares, leaving the business control primarily with the employees or selling the business in its entirety financially benefiting the LBO group and employees.