Together Blackstone, DLJ, and UP put a $45.50-per-share offer on the table and on June 6, Japonica dropped out—collecting a nice profit as the shares rose during the bidding. (Illustrating again that in the corporate raider game you can win by losing.) Although the $1.6 billion price was rich—Blackstone was paying eight times cash flow, twice what it had paid for Transtar—it was risking comparatively little: Blackstone injected $75 million of equity for a 72 percent ownership stake, while DLJ’s buyout arm put in $25 million for 24 percent. Union Pacific invested $100 million in preferred stock that paid a dividend. Though the preferred didn’t have the potential to rise (or fall) in value like common stock, UP had an option to convert it after five years into common shares for 25 percent ownership. Lenders, led by Chemical Bank and DLJ’s investment banking operation, furnished most of the remaining $1.4 billion.
On June 23, the buyout, Blackstone’s fourth, was put to bed.
But not to rest. Three months later, a nightmare set in.
In the intervening months, lenders and bond investors became nervous that the market had overheated, and the trading prices of junk bonds tumbled as investors ran for the hills. As in the financial crisis two decades later, credit suddenly tightened. Leverage wasn’t just out of fashion; it had become next to impossible to obtain. Indeed, the whole financing apparatus that had given rise to leveraged buyouts was sputtering, and the CNW deal looked like it might die along with it. The problem was a $475 million bridge loan DLJ had provided to finance the deal until CNW could arrange to float new bonds.
Bridge financing had been invented to compete with Drexel’s junk bonds. The process of issuing bonds was cumbersome and could take months: Elaborate prospectuses had to be prepared and circulated and buyers had to be lined up. Drexel was so adept at hawking junk, however, that companies and other banks involved in a deal would go forward with a takeover based solely on Drexel’s assurance that it was “highly confident” it could sell the necessary bonds. Other banks couldn’t do that, so instead they offered short-term loans that allowed the buyer to close the deal immediately and issue bonds later to repay the bridge loans. By 1988, DLJ, Merrill Lynch, and First Boston had each nibbled away at Drexel’s market share in leveraged takeovers this way.
But bridge lending was risky for the banks, because they could end up stuck with inventories of large and wobbly loans if the market changed direction or the company stumbled between the time the deal was signed up and the marketing of the bonds. The peril was magnified because bridge loans bore high, junk bond–like interest rates, which ratcheted up to punishing levels if borrowers failed to retire the loans on schedule. The ratchets were meant to prod bridge borrowers to refinance quickly with junk, and up until the fall of 1989, every bridge loan issued by a major investment bank had been repaid. But the ratchets began to work against the banks when the credit markets turned that fall. The rates shot so high that the borrowers couldn’t afford them, and the banks found themselves stuck with loans that were headed toward default.
The perils of bridge lending hit home that September and October when Robert Campeau, a Canadian financier and real estate developer, struggled valiantly to refinance a $400 million bridge loan he had taken out the year before with First Boston and two other banks to buy Federated Department Stores, the parent of the Bloomingdale’s, Abraham & Strauss, Filene’s, and Lazarus stores. After the abrupt failure of the $6.8 billion United Airlines buyout on October 13, the leveraged finance business all but ceased, Campeau couldn’t arrange borrowings to pay back the bridge, and Federated filed for bankruptcy. First Boston came close to toppling that year because of its loan to Campeau and two other bridge loans it made, for a takeover of the Long John Silver’s restaurant chain and for a buyout of Ohio Mattress Company, the parent of Sealy. The Ohio Mattress debacle was quickly dubbed “the burning bed” and remains, along with Campeau, a pivotal episode in takeover lore.
DLJ found itself in similarly precarious straits. It had planned to market CNW bonds to refinance the CNW bridge loan the third week of October 1989, but the United employee buyout cratered the week before and spooked the markets. DLJ now was saddled with two enormous bridge loans: the $475 million one for CNW and a $500 million loan to TW Services, owner of the Denny’s restaurant chain. Some of the money had been furnished by other institutions, but the bulk had come from DLJ and its corporate parent, Equitable Life. DLJ’s very survival now hinged on its bond desk’s ability to peddle CNW and TW Services bonds at a time when investors were scared to bet on highly leveraged companies.
To no one’s surprise, bond buyers demanded much higher interest rates than DLJ had bargained for—and much higher rates than CNW had expected to pay. So it was that one dark, blustery morning in mid-October, Schwarzman trekked downtown to DLJ’s headquarters across from the World Trade Center to hash out the terms for the bonds.
The senior banker on DLJ’s side of the table was Hamilton “Tony” James, who was the boss of both DLJ’s buyout group and its junk-bond sales force. Thirty-eight years old, he was composed under fire and, many who have worked for him attest, ferociously intelligent. In addition to creating and running the bank’s LBO and junk units, he led M&A and restructuring. Ostensibly the number-three executive, he was considered by many inside and outside the bank to be its de facto chief executive. Their tense face-off that morning was the first time that James, who years later would become Blackstone’s president and chief operating officer, had met Schwarzman.
Failing to refinance the bridge would be calamitous for DLJ and Blackstone alike. It would leave DLJ holding a giant, risky debt that it never expected to keep, and it would slam CNW with escalating interest payments that could sink the company and obliterate Blackstone’s equity. But James and Schwarzman had different ideas about how to solve the problem. DLJ was so desperate to get the bridge loan paid off that it was willing to offer bond buyers the moon. Blackstone, by contrast, was fixated on protecting its equity investment and didn’t want to endanger CNW with sky-high rates.
“DLJ was scared silly; there was fear in the room,” Schwarzman says. After some heated give-and-take, they reached a middle ground, with Blackstone agreeing to raise the rate on the junk bonds from 14.5 percent, already very high, to 14.75 percent and to award bond buyers a 10 percent equity share in CNW as well. But James and his team wanted yet another inducement for bond buyers: an offer to raise the interest rate on the bonds after a year if the bonds had declined in value. It was known as a reset clause, and as the junk-bond market turned increasingly jittery, investors had begun to insist on resets to limit their risk. DLJ demanded that one be added to the CNW package.
Reset notes were akin to adjustable-rate home mortgages, but instead of being tied to a broad index of borrowing costs, as adjustable mortgages typically are, the rates on reset notes are adjusted to reflect the going market value of the notes or bonds themselves. Suppose investors buy $1,000 bonds that pay $147.50, or 14.75 percent, annual interest, and the bonds’ market value falls to $970 a year later because interest rates in general have risen, making the old 14.75 percent bonds less desirable, or because the particular company is in trouble. The fall in value means that for an investor who buys them at $970, the bonds effectively are paying 15.2 percent interest. The reset clause would restore the bonds to their face value. To make up for the drop in price, the company would be required to boost the interest 3 percent to $152 a year, returning the bonds’ market value to $1,000, making the original bond buyers whole and happy.
As hard as DLJ pushed for a reset, Schwarzman pushed back just as hard. What if the bonds traded down to 90 cents on the dollar, triggering a rate hike to 16.4 percent? The market was capricious and Schwarzman was leery of open-ended risks: “I said, ‘I’m not doing a reset. I have to know my cost of money. What if there’s a bad economy? You could bankrupt the company!’ This was terrible corporate finance. But DLJ said, ‘We need a reset or we won’t do the deal.’ ”
Eventually Schwarzman sai
d he could agree to a reset provided that there was a 15.5 percent cap on the adjusted rate. After a back-and-forth, James agreed. The DLJ bankers insisted that the odds were strongly against the bonds’ falling so much in value that CNW would have to pay 15.5 percent. Schwarzman worried, though, that someone would figure out how to depress the bond price temporarily near the reset date so the new rate would hit the cap. A trader buying the bond then at a discount could make a killing when the interest rate was reset.
“I said that, somehow, some trader will find a way to make sure the bonds reset at the top of the cap,” Schwarzman recalls. “I said, ‘I’ll personally bet you $100,000 it will reset at the top.’ There was stunned silence. ‘Nobody is good for $100,000? What about $50,000?’ Again, silence. ‘How about $25,000?’ Finally, Tony James bet $5,000.”
James, too, recalls the exchange vividly. “We went back and forth a long time. This was the last issue we got hung up on. We couldn’t get Steve off it. Eventually, I said, ‘All right, Steve, I’ll bet you $5,000 this gets reset below the cap.’ ” (Asked if the wager started at $100,000 and descended in increments, James responds, “I’m going with my version.”)
The reset still wasn’t enough to sell all the bonds, and DLJ was stuck holding a lot of them in its own account, as well as a big slug of TW Services bonds. With DLJ still struggling, many employees received unsold CNW and TW bonds in lieu of cash bonuses that year. But DLJ staved off bankruptcy.
As for the reset, Schwarzman’s prediction was borne out. CNW’s bonds fell sharply, sending the interest rate up to 15.5 percent.
“Steve won the money, because the market continued to deteriorate,” says James. “He was gracious and had me give the money to charity.”
The seize-up of the markets and the turmoil that followed the downfall of the Campeau-Federated and United Airlines deals foreshadowed the credit crisis the financial world experienced a generation later. Though the downturn that began in 2007 lasted longer and inflicted far wider damage than that of the early 1990s—no major commercial or investment banks foundered in the early nineties as Bear Stearns and Lehman Brothers did in 2008—both shared a root cause: overexuberant borrowing. In both cases, scores of lending institutions went under and buyout firms strained to keep debt-laden holdings afloat. Then, as later, buyout players that had binged on leverage would have a nasty hangover.
Within months of the Federated and United problems, the biggest LBO ever—the deal that had come to symbolize the buyout business—was teetering on the verge of collapse.
KKR’s buyout of RJR Nabisco, the tobacco and food giant that peddled Oreo cookies, Ritz crackers, and Winston and Salem cigarettes, embodied the raucous, rapacious ethos of the late 1980s. It had everything: an imperial CEO who maintained a fleet of ten corporate jets, doled out $1,500 Gucci watches to employees, and surrounded himself with celebrities at company-funded golf events; Wall Street sharks circling the prey; and a teeming supporting cast of bankers and lawyers craving a cut. It was a tale of greed, excess, and hubris, with no small measure of farce. In the words of M&A banker Bruce Wasserstein, it was “the Roller Derby of deals.”
It began in October 1988 with the CEO, F. Ross Johnson, who was frustrated that RJR’s stock wouldn’t budge even though profits were up, lodging a bid. That month, with backing from Peter Cohen at Shearson Lehman Hutton, Johnson won his board’s support for a $75-a-share management-led buyout. Management would put up equity and would borrow the balance. His bid, one-third higher than RJR’s stock price, was far from stingy, but Johnson saw value in a company that could not win the stock market’s love. He calculated that if they bought at the right price, he and his financial backers could all make a fortune selling pieces of the business, capturing the hidden value for themselves.
For Cohen, the deal was a chance to resuscitate the M&A franchise Shearson had acquired with Lehman. But Johnson and Cohen quickly lost control of the situation, and of Johnson’s company. Henry Kravis and George Roberts thought Johnson had made a low-ball bid. Some outsiders figured that RJR could be worth as much as $100 a share if it were split up, and Kravis and Roberts calculated that they could top Johnson’s offer and still make a bundle by shedding parts of RJR and slashing fat. KKR decided to crash Johnson’s party, bypassing him and RJR’s board with a $90-per-share tender offer aimed directly at shareholders.
The sidewalk fisticuffs soon became a full-blown rumble. Ted Forstmann allied himself with Johnson, offering to help save the company from the clutches of Kravis, Forstmann’s nemesis. Most of Wall Street lined up on one side or the other with offers of financing. When it was all over, six weeks after it began, KKR had been forced to raise its offer to $109 per share, which the board accepted over a $112 bid from Johnson. Both bids offered shareholders a mix of cash and promissory notes—short-term bonds, in effect—but KKR’s terms on its notes were more generous.
By then Johnson had been publicly pilloried both for the rich golden-parachute package he had negotiated so he would be paid millions if he were deposed after a takeover and for trying to buy his company from his own shareholders at an unfairly low price. In this winner-take-all game, Johnson found himself without a job, and Cohen, his dreams of ascendancy dashed, resigned as chairman of Shearson Lehman in January 1990.
The takeover was the defining moment for the buyout industry. From the opening skirmish, it was seen for what it was—a battle between corporate America and a new breed of Wall Street titan. “The firm’s partners each take home in the neighborhood of $50 million a year, according to people close to the firm,” the New York Times gushed when KKR made its opening bid, pointing out the $2 billion KKR had made breaking up Beatrice Foods over the preceding years.
More significant in the long term, KKR emerged from the RJR battle perceived as a raider. Technically, KKR’s was not a hostile bid. In Wall Street parlance, a hostile bid is one made at a time when the company has not put itself up for sale, and KKR came in only after RJR’s board had put the company in play by entertaining Johnson’s offer. But that was a legalism. The fact was that KKR had bid against the management and won. It had snatched control away from the CEO and now promised to slash costs and carve up the company. To the man in the street, that was no different from what corporate raiders did.
At $31.3 billion, the RJR buyout smashed all records. It was more than three times the size of the next biggest, KKR’s $8.7 billion LBO of Beatrice in 1986. But KKR ended up paying a dangerously high eleven times cash flow, and there was a time bomb buried in the complicated mix of debt behind the buyout: $6 billion of reset notes whose interest rates were up for adjustment in February 1991. Like the CNW reset notes that had alarmed Schwarzman when Blackstone was arranging debt for that deal in October 1989, the interest on the RJR notes had to be readjusted upward if the notes traded below their face value. But unlike the CNW notes, where Schwarzman had insisted there be a ceiling on the maximum interest rate, the RJR reset notes had no limit on rates: RJR would have to pay whatever rate it took to restore the bonds to their original value so bondholders wouldn’t suffer a loss. With the investors fleeing risky securities, interest rates spiked and the notes were trading at such deeply depressed prices that RJR faced the prospect that the rate on the notes might jump from 13.71 percent to 25 percent. The hit would be lethal—adding more than $670 million in yearly interest costs that RJR could in no way afford.
By the spring of 1990, the situation was grave enough that Martin Lipton, a famed takeover attorney, warned Henry Kravis that Chapter 11 might be RJR’s only option. “There’s no way we’d do that,” Kravis retorted. If the company defaulted, KKR stood to lose its entire $1.5 billion of equity. In July, KKR did the only thing it could do to stave off bankruptcy: It doubled down, investing another $1.7 billion of equity to bail out RJR as part of a debt refinancing.
RJR managed to fend off insolvency, but the investment came to be seen not as a triumph but as the all-time booby prize, Exhibit A in the case against the LBO. The rip-roaring bes
tseller Barbarians at the Gate, by Wall Street Journal reporters Bryan Burrough and John Helyar, released in 1990, cemented the deal’s reputation as a monument to twisted thinking, greed, and megalomania. Years later, when KKR finally extricated itself from the last of its investment, it had lost more than $700 million. Investors in KKR’s record $6.1 billion 1987 fund ended up with a mediocre 9 percent return after KKR collected its cut.
A devastating front-page story in the Wall Street Journal that year completed the picture of KKR and the buyout business from another angle. The lengthy piece about KKR’s 1986 buyout of Safeway by Susan Faludi focused not on jousting executives and financiers but on the rank-and-file employees who lived through the buyout of the supermarket chain and the layoffs and divestitures that followed. The story was awarded a Pulitzer Prize the next year for “reveal[ing] the human costs of high finance.”
It was an ugly picture the Journal painted. KKR and Safeway’s management made four times their money when the chain went public again in 1990.
Employees, on the other hand, have considerably less reason to celebrate.… 63,000 managers and workers were cut loose from Safeway, through store sales or layoffs.… A survey of former Safeway employees in Dallas found that nearly 60% still hadn’t found full-time employment more than a year after the layoff.
James White, a Safeway trucker for nearly 30 years in Dallas, was among the 60%. In 1988, he marked the one-year anniversary of his last shift at Safeway this way: First he told his wife he loved her, then he locked the bathroom door, loaded his .22-caliber hunting rifle and blew his brains out.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 11
