Barbarians at the Gate

by Bryan Burrough

  They set up shop in the old Mutual of New York building on Fifth Avenue. Kohlberg preferred a low profile, so for years there was no name on the door. Roberts continued to work out of San Francisco. For overhead they raised $50,000 from each of eight investors, including Ray Kravis and the Hillman family of Pittsburgh. Kohlberg Kravis Roberts & Co. would take 20 percent of the profits from every deal, and charge a 1 percent management fee (later 1.5 percent).

  For five years they stuck to Kohlberg’s guiding tenets: the deals were always friendly, always with management, always careful. They identified many of their targets with the help of a Los Angeles finder named Harry Roman. It was difficult, uphill work. LBOs were still Greek to most people, and the trio spent much of its time explaining how three unknowns and a handful of executives could borrow enough money to buy an entire company. Their own low profile didn’t help. “Investment bankers, everyone, looked at us and said, ‘KKR, what is that, a delicatessen?’” remembered a Wall Street executive who worked for the firm in the seventies.

  Despite the physical distance between them, Kohlberg remained close to the sobersided Roberts, closer than with Kravis, who was still prone to sowing his wild oats. Roberts, quieter and, many believe, smarter than Kravis, had known Kohlberg longer and was considered his intellectual equal. When one of Kohlberg’s sons had problems as a teenager, Roberts took him into his California home. Kravis, on the other hand, seemed to be regarded by Kohlberg as a hardworking subordinate. The two men had little in common besides their work. On weekend outings Kohlberg would wear chinos and hiking boots. Kravis would come in Italian slacks and Gucci loafers. After working side by side for sixteen-hour days, Kohlberg headed home to sleep, but Kravis headed out on the town with his wife. “Jerry would see Henry going out and remark dryly, ‘Oh, off again, Henry?’” said a former Kohlberg Kravis associate.

  The deals came in spurts: three in 1977, none in 1978, three more in 1979, including the first buyout of a major publicly held company, Houdaille Industries. Then, after a small deal in 1980, Kohlberg Kravis went on a tear in 1981, completing six deals and generating the first spate of press coverage for the tiny firm.

  During this period the trio fine-tuned its craft. They found larger companies could be acquired as easily as small ones, for the simple reason that they had larger cash flows; by diverting that money to pay down its debt, Kohlberg Kravis was able to use a company’s own strengths to acquire it. They began accumulating pools of money from investors, allowing them fast access to larger amounts of cash. Beginning with a $30 million fund in 1978, they raised a series of steadily larger pools, eventually reaching $1 billion in their fourth fund in 1983. The size of the deals grew in lockstep, reaching a peak during this period with the $440 million buyout of a Hawaiian construction company, Dillingham Corp.

  After a company was acquired, Kohlberg, Kravis, and Roberts kept a close watch on its budgets, but otherwise gave its management more or less free rein to streamline and meet its mountainous debts. In most cases it worked like a charm. When it didn’t, as in the firm’s second buyout, an oil field services firm named L. B. Foster that ran into the teeth of an industry slump, heads rolled, and new management was swiftly brought in. After five to eight years they resold their companies, or took them public again, often getting three, four, five, even ten times their original investment. By 1983 Kohlberg Kravis claimed an average annual return of 62.7 percent to their investors. Their own 20 percent stake made the three men rich.

  For six years they plugged along, quietly dominating their obscure little niche of finance. Then, as so often happens on Wall Street, someone noticed. In 1982 an investment group headed by William Simon, a former treasury secretary, took private a Cincinnati company, Gibson Greetings, for $80 million, using only a million dollars of its own money. When Simon took Gibson public eighteen months later, it sold for $290 million. Simon’s $330,000 investment was suddenly worth $66 million in cash and securities.

  It was a fluke, an accident of timing, but it turned heads on Wall Street. Gibson Greetings became its equivalent of gold at Sutter’s Mill. Suddenly everyone wanted to try this “LBO thing,” even though few knew how it worked. And try it they did. Measured by the total sales of acquired companies, the LBO phenomenon increased tenfold between 1979 and 1983. By 1985, just two years after Gibson Greetings, there were eighteen separate LBOs valued at $1 billion or more. In the five years before Ross Johnson decided to pursue his buyout, LBO activity totaled $181.9 billion, compared to $11 billion in the six years before that.

  A number of factors combined to fan the frenzy. The Internal Revenue Code, by making interest but not dividends deductible from taxable income, in effect subsidized the trend. That got LBOs off the ground. What made them soar was junk bonds.

  Of the money raised for any LBO, about 60 percent, the secured debt, comes in the form of loans from commercial banks. Only about 10 percent comes from the buyer itself. For years the remaining 30 percent—the meat in the sandwich—came from a handful of major insurance companies whose commitments sometimes took months to obtain. Then, in the mid-eighties, Drexel Burnham began using high-risk “junk” bonds to replace the insurance company funds. The firm’s bond czar, Michael Milken, had proven his ability to raise enormous amounts of these securities on a moment’s notice for hostile takeovers. Pumped into buyouts, Milken’s junk bonds became a high-octane fuel that transformed the LBO industry from a Volkswagen Beetle into a monstrous drag racer belching smoke and fire.

  Thanks to junk bonds, LBO buyers, once thought too slow to compete in a takeover battle, were able to mount split-second tender offers of their own for the first time. Suddenly LBOs became a viable alternative in every takeover situation; because they held out the promise of operating autonomy and vast riches, Kohlberg Kravis and other firms were swamped with requests from chief executives to become “white knight” rescuers of their raider-besieged companies. It was a symbiotic relationship repeated in deal after deal: raider seeks target; target seeks LBO; and raider, target, and LBO firm all profit from the outcome. The only ones hurt were the company’s bondholders, whose holdings were devalued in the face of new debt, and employees, who often lost their jobs. In the sheer joy of making money, Wall Street didn’t pay too much attention to either group.

  No sooner did LBOs blossom than critics took aim. The vast debt assumed by post-LBO companies worried many, including those in government. In mid-1984 the chairman of the Securities and Exchange Commission predicted that “the more leveraged takeovers and buyouts now, the more bankruptcies tomorrow.” A Republican SEC commissioner decried LBOs as “little more than a charade.” Proponents, of course, argued that LBOs actually strengthened the business community by cutting corporate flab and building leaner companies.

  Curiously, the loudest outcry came from the raider-ravaged corporate community, where Main Street executives saw the mounting power of LBO buyers as the next plague to be unleashed by Wall Street. A top executive of Goodyear Tire & Rubber, for one, labeled the LBO “an idea that was created in hell by the Devil himself.”

  As the spiritual leader of the LBO community, Jerry Kohlberg by 1983 was growing uncomfortable with changes in the industry he helped spawn. He still favored small, friendly deals initiated by pull-up-a-chair talks with older gentlemen. The new breed of LBO buyer was typified by the young, hard-charging investment bankers who now flocked to Kohlberg Kravis with ideas for new deals. Kravis and Roberts, then in their late thirties and coming into their own as deal makers, were magnets for these men.

  “This is really a young person’s game,” says Richard Beattie, a Manhattan lawyer who had worked closely with Kravis since Boren Clay. “By now Jerry is fifty-three, fifty-four. Investment bankers don’t call Jerry. They call Henry and George. They’re the same age. Jerry begins to feel left out. He’s not part of the action anymore.”

  As the LBO game grew faster, Kravis and Roberts took on more and more of the firm’s deal-making responsibility. In 1984 they complete
d the first $1 billion LBO, and took Kohlberg Kravis on a spree of other large deals. As buying opportunities mushroomed, the pair pushed to enlarge the firm and add staff. New men were added, but Kohlberg blocked hiring even more. Kravis and Roberts pushed for more and larger deals, and Kohlberg blocked many of those, too. Inside the firm, Kohlberg acquired the inevitable moniker, “Dr. No.” Kravis complained that Kohlberg was stuck in the sixties. Behind his back, the two cousins began to grouse that Kohlberg was holding them back. “Jerry was older, and he never wanted to work as hard,” Roberts recalled. “The reason Jerry was so negative was that he wasn’t reading and understanding what was going on.”

  As the firm grew—by 1983, it had eight deal makers, by 1988, fifteen—tensions rose. Factions developed. Junk bonds produced an ever more complicated stream of Rubik’s Cube financial structures. Kravis and Roberts were so busy Kohlberg could no longer keep abreast of every deal. Outside parties began shouldering more and more of the daily work, and Kravis and Roberts soon were orchestrating small armies of investment bankers and lawyers. “Jerry began to pull back,” says his longtime friend George Peck, a Kohlberg Kravis consultant. “He was less comfortable with all that. He was starting to get a real sense of despondency.”

  Then, in late 1983, Kohlberg began experiencing mysterious dizzy spells. Tests found a blood clot in his brain, and in early 1984 he underwent surgery at New York’s Mount Sinai Hospital to have it removed. During his hospital stay, a friend says, “Jerry [got] a little offended because [Henry and George didn’t] visit him very often.” Afterward, Kohlberg, impatient to return to his normal routine, insisted on convalescing at his home in St. Croix. After the flight down, a blood clot in his lung was found. Rushed to the hospital, two close friends say, Jerry Kohlberg nearly died.

  He attempted a return to work in mid-1984 but, plagued by headaches and lethargy, gave up and remained away for months. When Kohlberg finally returned to work again, he was unable to handle his former workload. Tired, medicated, he left many days by noon. Other days, said Peck, “Jerry would get up, plan to come in at seven-thirty, then have a splitting headache and have to stay home.”

  “Healthwise, Jerry was not ready to come back,” said Paul Raether, a former investment banker who was named the firm’s fifth general partner in 1986. When “Jerry comes back in 1985, he’s in the flow, but he’s not in the flow. He’s working maybe twenty-five hours a week. He can’t keep up in the day-to-day work. That created tensions. Things start to pile up because Jerry’s behind. Decisions aren’t made as fast as they should be, and that creates more friction. Another problem was Jerry wasn’t always there. He lost his train of thought easily. Jerry doesn’t believe it. If you told him I said that, he’d say I’m full of shit. But it’s true. It’s just a fact. Sometimes he just wasn’t there.”

  The tensions between Kohlberg and his two partners broke into the open during the fight for Beatrice, when Kohlberg opposed their plan to launch a hostile tender offer. There were awkward scenes when Kohlberg demanded to attend a meeting or strategy session to which he hadn’t been invited. “The person that has the greatest problem with all this, of course, is Jerry himself,” says a Kravis intimate. “He develops a great deal of anxiety about being left out of the business, walking into people’s offices at the wrong time, always asking what’s going on. He begins insisting for the first time on formal lines of communication.”

  It was a difficult period for Roberts and Kravis, who realized they might not be able to continue as they had before. After Beatrice, Kohlberg forced the issue by insisting that his responsibilities within the firm be defined. It was a painful dialogue for all involved.

  “What should I do?” Kohlberg would ask.

  “What do you mean, ‘What should I do?’” Kravis would reply. “I don’t have to tell George or the others what to do. Doesn’t that tell you maybe it’s time for a change?”

  They had the same arguments over and over. You want it the way it was in the old days, Kravis would say, and it can’t be. It just can’t be. Times have changed.

  “But we were partners when we started,” Kohlberg said.

  “That’s true,” Kravis said. “But life changes. The business has changed.”

  The simple fact was, Kravis and Roberts no longer needed their former mentor. In his absence they had completed a number of difficult, high-profile deals, including the $2.4 billion buyout of Storer Communications. “George and Henry said, ‘Hey, we’re doing pretty well,’” says George Peck. “‘If Jerry’s not in today, no big deal. Things are being taken care of.’ That just killed Jerry.” Says Roberts, “As we needed less and less help, Jerry wanted to help more and more.”

  In the months to come, the gap between Kohlberg and Kravis was widened by the stark difference in their life-styles. Kohlberg was a home-body, married to the same woman for forty years. Money hadn’t changed him. He dressed simply, led a quiet family life, and spent his free time playing tennis or reading thick volumes of fiction or biography. His idea of entertaining was tossing a softball around on a Sunday afternoon and retiring early to read. “Getting Jerry to go out to a cocktail party,” says a friend, “is a major event.”

  Kravis, on the other hand, lived for the lush life. His first marriage on the rocks, Kravis began seeing Carolyne Roehm, and the couple quickly became a fixture of society pages. Every night, it seemed, they were photographed at some black-tie function or another, laughing with flashy friends such as the Donald Trumps. Kohlberg didn’t think it was the way a grown man ought to act; it was ostentatious, and it gave the firm a bad image. “It came to bother Jerry a lot,” says a Kohlberg friend. “It came between them to the point where Jerry couldn’t stand to go to Henry’s apartment on Park Avenue, there was so much wealth.”

  Rather than confront Kravis, Kohlberg took his complaints to his kindred spirit, Roberts. Roberts counseled restraint. “Look, Henry is happy,” he told Kohlberg. “Carolyne is a fashion designer, and fashion designers need publicity. You know Henry has always been more a social animal than you and me. Let’s not try to be running everyone’s lives.”

  For months the debates on Kohlberg’s future dragged on. Kravis thought Kohlberg was being egged on by his son James, a former journeyman tennis player now working for Roberts in San Francisco. Much of the time the three principals communicated via their friends, Beattie and Peck, who tried to keep them together.

  It was no use. In the end, the crux of their disagreement came down to two things: money and power. To Kravis and Roberts, Kohlberg wanted too much of both. On the firm’s founding, they had agreed that Kohlberg would take about 40 percent of the profits, with Kravis and Roberts taking about 30 percent apiece. As other partners joined, their shares came out of Kohlberg’s take. It was painful for the two cousins to tell Kohlberg he wasn’t pulling his load. But as a result, they felt he shouldn’t be allowed to remain an equal partner. “It just wasn’t fair,” Roberts recalled quietly.

  The firm’s charter provided for majority rule among the trio. According to Roberts, Kohlberg now demanded it be unanimous, in effect giving him veto power over major firm decisions. It was the final straw. “We were prepared to give him a large interest, to let him stay, to treat him with due respect, but we wouldn’t give him veto power,” says Roberts. “It just wasn’t right.”

  There was talk of Kohlberg becoming chairman emeritus, but he wasn’t ready to retire. Eventually tempers flared. “There were scenes, you know, when Jerry said, ‘I founded this firm. You guys wouldn’t be here without me,’” Raether recalled. “None of us liked the way it worked out in the end.”

  When Kohlberg suggested he might leave, neither Kravis nor Roberts argued with him. Both sides hired lawyers, and a severance agreement was negotiated over a period of months. By the spring of 1987 it was completed and, in June, Kohlberg’s departure was announced to the firm’s investors. The rift between the partners was hinted at but never explained. Kohlberg and his son, along with George Peck, soon founded their
own LBO firm, Kohlberg & Co., which pointedly concentrated on small, strictly friendly deals. Kohlberg almost never spoke of the rift, and when he did he hinted of his disapproval of Kravis and Roberts’s growing appetite for larger fees and bigger, more aggressive deals. “I won’t restrict myself to small transactions,” he told The New York Times in 1987, “but I’ll stick with deals where reason prevails.” Kravis and Roberts read the comments and thought Kohlberg was erecting a smoke screen to hide the real reasons behind his departure.

  “It makes me sad,” Roberts said in a mid-1989 interview. “It’s like a divorce. Of the twenty-four years I worked with Jerry, nineteen were idyllic. The last five were not…. I feel like I lost a good friend. The decision we made for him to leave was best. But personally, it was very tough on me. Still is.”

  By the time Jerry Kohlberg left Kohlberg Kravis, his office had lain empty so long it was regularly used by visiting lawyers. With its Talmud and collection of Lucite tombstones, the lawyers dubbed it “the LBO library.” When the offices were remodeled in 1989 after a fire, Henry Kravis had it turned into a stairwell.

  Long before he became a major force on Wall Street, Kravis was a fixture of New York society circles, thanks to his extended courtship of Carolyne Roehm. Before the creation of Carolyne Roehm, fashion designer, there was Jane Smith, specialist in Sears polyester sportswear. The only child of a pair of teachers, little Janey enjoyed an idyllic childhood in tiny Kirksville, Missouri. At five she saved her money for her first fashion purchase, a rhinestone necklace from the Sears catalog. At thirteen she saw Susan Hayward in Back Street and decided she wanted to be a fashion designer.