The new management philosophy was poetically summed up in the change in the company’s motto, from “Safeway Offers Security” to “Targeted Returns on Current Investment.”
Coming the same year as Barbarians, the story helped crystallize the reputation of buyout moguls as ruthless job cutters who looted companies of cash and assets for the sake of short-term profits.
It was not just the layoffs that made the Safeway buyout emblematic of the eighties. The Safeway saga had all the ingredients of a classic LBO of its era. The deal emerged after a father-and-son team of raiders began circling the chain, which they viewed as a lumbering business run by complacent managers who didn’t appreciate the company’s undervalued, underutilized assets. There was a bidding war and the company emerged with debt heaped upon it.
The true consequences of the Safeway buyout, however, were rather different from what the Journal portrayed. The first three years under KKR were indeed tumultuous, as Safeway shrank its business by 30 percent and sold 40 percent of its stores. Tens of thousands of employees did pay a steep price. But KKR reshaped a languishing company and positioned it to thrive in the next decade. In that way, it was a case study in the economic payoff from the upheaval and restructuring wrought by the raiders and buyout firms.
Safeway may have been a “a company legendary for job security,” as the Journal said, but that was another way of saying that it had become bloated. Its labor costs had shot up and were a third higher than those of its competitors (most of which were also unionized) because Safeway had been preoccupied with expansion rather than profitability. Management had been virtually hereditary. Safeway’s CEO at the time, Peter Magowan, had succeeded his father at age thirty-seven, and his grandfather, Charles Merrill, a founder of Merrill Lynch, had been instrumental in assembling the chain through mergers in the 1920s and ’30s as an investor, a banker, and later as head of the company.
Safeway had a strong brand in its home market in northern California as well as the Pacific Northwest and Washington, D.C., but was competing ineffectively and losing money in many others. Moreover, it did not even have internal mechanisms to gauge the profitability of its divisions or its investments.
In 1986, Herbert and Robert Haft, two sometime corporate raiders whose family had owned the Dart Drug chain, thought they could do a better job running Safeway and began buying up the stock as a prelude to a hostile takeover bid. In July, after amassing a 6 percent stake, they went directly to shareholders with a $58-a-share bid, backed with a promise from Drexel to provide billions in financing.
KKR had already been eyeing Safeway, but Magowan had brushed off several feelers from the firm. Now, with his job threatened, he was receptive when KKR offered to be a white knight, allying with management to take the company private. Soon KKR and Magowan had formulated a $4.8 billion, $69-a-share offer, which Safeway’s board recommended to shareholders when the Hafts refused to up their bid beyond $64. KKR would put up $132 million of equity for about a 90 percent ownership interest, with management taking a 10 percent stake. (Morgan Stanley and Bankers Trust backed KKR’s bid since Drexel was spoken for.)
The Hafts were outbid but walked away with a $153 million profit—double the money they’d spent buying Safeway stock—including millions Safeway paid to settle a lawsuit over its defensive tactics during the battle. Other shareholders did well, too, for KKR’s offer was 70 percent above the stock’s price when the Hafts began buying up shares.
While KKR kept Magowan on as CEO, he would now be playing according to KKR’s script as Kravis, Roberts, and their partners put Safeway through radical reconstructive surgery.
Lowering labor costs was only one piece of KKR’s strategy. Equally important was getting out of markets where Safeway was an also-ran. Safeway quickly sold off its Los Angeles and San Diego stores, where it had small market shares, to stronger competitors. Soon its Salt Lake City, Arkansas, Oklahoma City, and Kansas City stores were off-loaded, also to other chains. Out went the profitable British subsidiary, sold to reduce debt. Meanwhile, a British wine retailer that wanted to branch into the United States bought Safeway’s struggling Liquor Barn operation.
What made Safeway so ripe for an LBO was the fact that it had never scrutinized how it used its capital, whether its investments were paying off, or where it was making and losing money. KKR set to work at once analyzing Safeway’s real estate to determine which properties were so marginal as grocery stores that the company was better off disposing of them. The test was not what the company had paid for properties years before, but what they were worth today. That was the real measure of the capital tied up in the property, and viewed that way, many of the stores didn’t pass muster. Those were sold off.
Headquarters staff, meanwhile, was slashed 20 percent, and managers down through the ranks were given new financial incentives to increase profitability and returns on investment rather than just to increase sales, at whatever cost, as they had in the past.
At a time when no-frills warehouse stores were gaining big market shares with their low prices, Safeway’s labor costs put it at a tremendous competitive disadvantage. Its rank-and-file workers thus inevitably bore the brunt of cost-cutting at the stores Safeway retained. The company succeeded in renegotiating terms with its unions in most regions, cutting wages for tens of thousands of employees. In the Dallas area, however, where Safeway’s competitors were not unionized, Safeway’s unions demanded that Safeway sell its stores to a unionized company and refused to grant concessions when their contracts expired. Without some break on labor costs, Safeway said it would not be able to find a buyer for the stores as a unit, and it opted to shut 131 stores and sold them piecemeal, mainly to smaller, nonunionized chains. Some 8,600 employees, mostly union members, were let go.
The slashing “cut plenty of muscle with the fat, both from [Safeway’s] holdings and from its labor force, and deferred capital improvements in favor of the all-consuming debt,” the Journal declared in its 1990 piece. But Safeway’s growth in the nineties disproved that. When the restructuring was complete, Safeway had contracted from twenty-four hundred to fourteen hundred stores, and from $20 billion in sales to $14 billion—a shrinking act that would have been virtually unthinkable for a public company to attempt, because stockholders and investment analysts would never tolerate the risks. Yet, remarkably, cash flow rose 250 percent during the coming decade. Capital spending, which had been cut in half from 1987 to 1989 during the divestiture program, was restored in 1990 after Safeway’s debt had been reduced and the company set out on a new expansion, this time targeting profitable markets.
The full history of the Safeway buyout actually debunks many of the clichés about LBOs. Yes, there were big job and pay reductions, but the company’s workforce remained 90 percent unionized, and the asset sales, cuts, and new incentives had a dramatic impact on Safeway’s profitability, which had lagged for years. By 1989, three years after the buyout, the chain’s operating profit margin, which had been 2.2 percent in 1985, was up almost one half to 3.2 percent. Far from hamstringing the company, the brutal pruning of Safeway laid the foundation for an extraordinary run after the company went public in 1990. After a brief dip in the early nineties, Safeway’s stock skyrocketed more than twenty times in value, going from $2.81 at its IPO in 1990, adjusted for stock splits, to $62 by 2000, the year KKR sold the last of its stake. The buyout had been leveraged in the extreme, with just 3 percent equity, so the payoff was huge: KKR made more than fifty times its money. The deal also flew in the face of the notion that buyout firms seek quick flips. Despite its big profit early on, KKR retained a stake in Safeway for nearly fourteen years.
The strategy behind KKR’s restructuring of Safeway was not unique to buyout firms. Spurred by new business school teachings about measuring returns on capital, executives and boards of directors were increasingly reexamining their businesses. If we sold this factory, could we reinvest the money and make a higher return than we do now? Would we be better to focus on the f
astest-growing and most profitable parts of our company? Could we raise money to invest in them by selling off other subsidiaries?
These were the same questions people like Kravis and Roberts had been asking as they sized up investments. The pressure exerted by the enormous debt loads on companies that had undergone LBOs accelerated the process greatly, but the same relentless, unsentimental reexamination of companies by their managers was becoming the norm throughout the American corporate world. Boards and CEOs knew full well that if they didn’t perform the analyses and make the changes, someone else might take over their company, sack them, and do it themselves. A decade of looking over their shoulders at the raiders and the buyout firms enabled by Drexel’s debt had brought that lesson home emphatically.
“These people were very influential,” says Robert Bruner, the dean of the Darden School of Business at the University of Virginia. Not only did they help unlock resources and displace sleepy managements, he says, but “the buyout wave and the raiders really liberalized the way we look at the generation of value by companies and the delivery of that value.”
It was the beginning of a new age in market capitalism, one with constant upheaval and less security for executives and workers alike. But it instilled a discipline and incited a new drive for efficiency with payoffs for the economy as a whole—so much so that it permanently reshaped the thinking of public company managers. No longer were the public stock markets populated with scores of companies worth less as a whole than the sum of their parts. As managers worked to eliminate that disparity, there were fewer and fewer easy pickings for the raiders and buyout firms.
Financing takeovers also grew harder. When the credit markets finally opened back up in the early nineties, lenders demanded that buyers front 20 or 30 percent or more of the entire price in equity, not 5 to 10 percent as in the 1980s. That sidelined many raiders, who had drawn sustenance from Drexel and typically did not have big pools of equity themselves. In the 1990s raiders largely ceased to be a force.
For buyout firms, the game had to change as well. No longer could they lean so heavily on the power of leverage to deliver gains or simply break apart what they’d bought. Now they would have to take companies more or less as they were and burrow deeper into the nitty-gritty of their operations to make them worth more. “Value creation” would be the new mantra.
CHAPTER 9
Fresh Faces
RJR Nabisco and other LBOs were not the only victims of the debt crisis that set in at the end of 1989. From KKR’s Midtown Manhattan office to Drexel’s posh Beverly Hills digs and smalltown savings and loans across the Sun Belt, credit was suddenly in short supply. The Drexel junk-bond operation had been operating under a cloud since late 1986, when news surfaced that the Securites and Exchange Commission had begun an insider-trading investigation of Drexel and Michael Milken, who not only created the junk-bond market but had stabilized it through thick and thin. The bank pleaded guilty to criminal charges in December 1988 and agreed to pay a $650 million fine. Milken was indicted for his role in March 1989 and left Drexel. The impact was not immediate, but the elaborate set of relationships Milken had used to sustain the junk market, and to rescue his clients when they stumbled and were in danger of defaulting, was being undermined. No more could a troubled company have faith that Milken would refinance its debt to keep it going. No longer was he there to call in favors, tapping one client to buy another’s bonds, as he often did.
The junk market had cooled in 1989, but that October it completely froze up. The precipitating event was the breakdown of the $6.8 billion employee-led buyout of United Airlines. When the senior lenders for that deal got cold feet, it spooked other banks, which, in turn, swore off LBOs. Across the board, investors began to take a new look at risks, and junk bonds were one of the riskiest forms of debt. It became nearly impossible to sell them.
The turn in the market sank Drexel. With losses piling up, the bank filed for bankruptcy in February 1990, putting a nail in the high-yield coffin and punctuating the end of the era. The junk-bond market, which had churned out $20 billion to $40 billion in new issues annually from 1986 to 1989, all but evaporated. In 1990, just $1.4 billion of new bonds were sold.
At the same time even larger problems were brewing far from the big-city banks. The savings and loan industry, which had been deregulated in the early eighties, was melting down. S&Ls had been instrumental in financing a decade-long real estate boom, and in a mix of incompetence, greed, and cronyism, they had used their deposits to make speculative loans. By the end of the decade, S&Ls were going bust in droves. Federal regulators seized 185 in 1988 and 327 in 1989. Real estate prices collapsed over wide swaths of the United States where the S&Ls had lent with abandon for new offices and subdevelopments. Many of the S&Ls had also fed at Drexel’s trough, both issuing junk bonds and buying those of other Drexel clients. When they were taken over and their assets sold, there was that much less demand for the bonds.
The credit lockdown and the recession that followed in 1991 and 1992 put an end to the lavishly leveraged, big-ticket takeovers of the previous decade. Schwarzman embellishes only slightly when he likens DLJ’s frenzied scramble to sell the CNW bonds in October 1989 to “catching the last helicopter out of Vietnam.” Nearly three years would pass before there would be another sizable junk-bond-financed LBO, a $1.5 billion deal by KKR for the insurer American Re, and then KKR had to invest 20 percent of the price in equity—far more than it had been accustomed to stumping up.
Blackstone, too, had to lower its sights. While its first six deals had averaged $1.1 billion in size, the average from 1991 to 1995 fell to barely $300 million. Blackstone wouldn’t attempt another deal on the scale of the $1.6 billion CNW deal until 1996.
The financial meltdown soon worked a Darwinian thinning of the ranks of LBO firms, crippling some, eviscerating others. The partners of Gibbons, Green, van Amerongen, a twenty-year-old pioneer of the LBO, split up in a bitter squabble over who was to blame for a string of wipeouts. Adler & Shaykin, another established boutique, flamed out after most of its half-dozen investments bombed and its investors demanded to be released from their future funding commitments. Adler & Shaykin’s second, $178 million fund also would be its last.
Ken Miller, the former Merrill Lynch M&A wunderkind who entered the buyout field in 1988 with his new Lodestar Group amid great fanfare, ended up funneling more than half his $300 million fund into one misguided investment, the 1989 purchase of Kinder-Care Learning Centers, a day-care-center operator. When Kinder-Care collapsed three years later, obliterating most of Lodestar’s equity, Ken Miller’s brief heyday as a buyout artist was over.
Wasserstein Perella, the other firm whose debut buyout fund in 1988 unleashed a blizzard of hype just as Blackstone’s LBO business was getting under way, survived but was bloodied. Like Lodestar, it put too much of its money on one horse, risking—and ultimately losing—just over one-third of its $1.1 billion fund on a $3 billion buyout of England’s Gateway supermarket chain in 1989. Though it wrung big profits from smaller bets on the cosmetics supplier Maybelline and Pneumo Abex, a landing-gear maker, Wasserstein Perella was indelibly tarnished by the Gateway debacle, and the firm, later renamed Wasserstein and Company, never raised a buyout fund as large as its first.
The savage shakeout forever altered the industry’s power structure. Never again would KKR lord it over the business to the degree it had in the 1980s. Merely by surviving and safeguarding its investors’ money as more ballyhooed firms bombed out, Blackstone was positioned to compete on a more equal footing in the years ahead.
The upheaval also set the stage for a new generation of players to come to the fore, some of whom had set up shop around the time Blackstone’s buyout operation was launched. Four of the newcomers, along with KKR and Blackstone, became dominant players in the 1990s.
In Washington, D.C., in 1987, David Rubenstein, a brusque former lawyer and top Carter administration official, and William Conway, a former CFO of MCI Commun
ications, formed the Carlyle Group, which carved out a unique niche through its knowledge of government’s ins and outs. Carlyle notched its first big score in GDE Systems, a defense electronics business it bought in 1992 and sold in 1996 for eight times its money. Because it chalked up most of its other early successes in the defense and aerospace industries, it gained a reputation for Washington-centric deals even though it soon branched abroad and to other sectors.
In Texas, meanwhile, Tom Hicks, a charismatic deal maker who’d earned a fortune on LBOs of soft-drink makers Dr Pepper and Seven-Up, broke up with his longtime partner, Robert Haas, and raised a $250 million fund with a new partner, John Muse. In one of its early deals, Hicks, Muse and Company, the firm they formed in 1989, bought Morningstar, a perilously indebted Houston dairy. They injected $30 million of equity, shoring up its balance sheet, and took it public a little over a year later. From its quick flip, Hicks, Muse milked more than a fourfold gain.
Two of the biggest emerging stars, Leon Black and David Bonderman, stepped to the front of the pack a year or two later when the buyout business was shut down in the early nineties by demonstrating that they were shrewd opportunists who could seize on the crisis to buy up distressed businesses at fire-sale prices.
Black, a towering man with the intimidating bulk of a linebacker, had been one of Drexel’s stars, rising by his midthirties to head Drexel’s M&A bankers. Based in Drexel’s New York office, he had instigated a host of takeover campaigns, which he passed off to Michael Milken in Beverly Hills for financing. Black emerged unscathed by Drexel’s scandals and collapse and proved as adaptable as a chameleon. In 1991, with the economy at its worst and the junk-bond market at its nadir, state regulators in California seized Executive Life Insurance Company, a prime customer of Drexel’s that had gone under as its bond holdings shriveled in value. When the state liquidated the company, Black, backed by money from a French bank, swooped in with a winning bid and snared the insurer’s $8 billion junk-bond portfolio at less than 40 cents on the dollar. Black was perfectly situated to evaluate the bonds, for he had advised many of the companies behind them. When the economy revived, he unloaded the securities piece by piece for more than a $1 billion profit, winning him an enduring place in the top tier of vulture investors. Apollo Advisors, Black’s new firm (later renamed Apollo Management and then Apollo Global Management), ultimately reaped more than $5.7 billion in gains on the $2.2 billion it raised from 1990 to 1992, from Executive Life and other distressed assets.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 12
