Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion

by Steven M. Davidoff

  The public and political elements of dealmaking have become increasingly important over the years. The public here includes not just legislators but the executive bodies of the states and federal government; regulators on a broad-based level including the SEC, the Federal Trade Commission, and the Federal Reserve, as well as those with a particular industry focus; unions and employment bodies; media; lobbying groups; and the public generally. Many of the deals described in this book such as InBev N.V./S.A.’s hostile takeover of Anheuser-Busch, Dubai Ports World’s failed acquisition of a number of U.S. ports, and a private equity consortium’s successful acquisition of Texas utility TXU, Inc. were more public successes than anything else.

  Thus, going into the sixth wave, deals had become a complex affair—mixing economics, politics and interest groups, regulation, public relations, and personality. But the sixth wave brought about its own revolution, which threatens to upset this mix.The events of the past few years have changed dealmaking as the quickening pace of financial innovation and extraordinary growth in the global capital markets have changed the way takeovers are structured and implemented. During the sixth wave, from 2004 to 2008:

  • Dealmaking became a truly global business.

  • Sovereign wealth funds first appeared.

  • Private equity dominated takeovers and then simply disappeared.

  • Hedge funds became ubiquitous, driving shareholder activism and takeovers.

  • Derivatives became increasingly complex and a controversial, frequent tool of activist hedge funds.

  • The structure of strategic transactions changed in light of the credit bubble, the ensuing crisis, and the drying up of cash financing.

  • Private markets became an increasingly important source of capital.

  • The public became an increasingly important element of transactions.

  • A series of strategic hostile takeovers transformed the playing field for these unfriendly bids.

  In particular, shareholders led by activist hedge funds have become more active than ever before. Together with the good corporate governance movement led by the corporate governance proxy advisory services, they are driving a more disciplined approach to dealmaking and corporate conduct.These are new actors and new weapons that are unlike anything ever before seen.

  The changes fostered by these developments have been skewed by the financial crisis and the massive market panic that occurred beginning in September 2008. The crisis has been a crucible through which the recent changes in dealmaking have crystallized and become self-apparent. The stresses brought upon the market created their own magnifying lens, exposing the flaws in the deal system but also shaping its future. It has exploded the old investment banking model and caused actors to reassess the role of financing, particularly debt, in dealmaking.

  The result is a transformed marketplace but also a regulatory system and an approach to dealmaking that is a step behind. The deals that follow are about the past years of frantic change and crisis, the future of deals and dealmaking, and the appropriate response of dealmakers and regulators. It is about the glory and failures of dealmaking and the role of dealmakers. It is about the transformative transactions in the new millennium and a history of dealmaking in a soaring and perilous time. It is about how deals will be done, and perhaps regulated, in the future.

  But to understand dealmaking today, it is first necessary to take a step back and explore its driving transformational force in the sixth wave—private equity.

  Chapter 2

  KKR, SunGard, and the Private Equity Phenomenon

  The phenomenon of the sixth takeover wave, private equity, is a key force behind the current crisis-driven change in the takeover market.1 Private equity dominated the sixth wave, accounting for $1.02 trillion in U.S. acquisitions or 20 percent of all domestic takeovers from 2004 through 2007.2 At the time private equity was not only ubiquitous but also seemingly unstoppable. From the 2007 acquisition of Chrysler LLC by Cerberus Capital Management LP to the $44 billion acquisition of the power company TXU, the largest U.S. private equity deal ever, it appeared that private equity would not only be the preeminent force in takeovers but also transform the way companies operated and raised capital. As with previous booms, the words paradigm shift were murmured a lot, and many even spoke of private equity ending the primary role of the public markets for equity capital.3

  Of course, we all know what happened. The credit market collapsed, the economy and housing and stock markets went into decline, and private equity entered into its own tumultuous period as these firms repeatedly attempted to terminate or otherwise escape their obligations to complete acquisitions agreed to in far better times.The failure of so many private equity deals left many seeking to assign blame for the collapse, pointing fingers at attorneys, investment bankers, banks, and private equity firms themselves. The private equity market came to a standstill, as credit dried up and targets became skittish about the ability of private equity firms to complete acquisitions. But the failure of private equity, the reasons for its collapse, and the implications for the future of dealmaking are the subject of Chapter 4.

  This chapter is about the seeds of this late failure. It is about the origins and history of private equity, a story that set the foundation and tension points for private equity’s downfall, as well as for the general transformation it wrought in the takeover market. This story is not all about failure. This chapter is also about how private equity came to be such a game-changing force. Here, we actually have a deal that crystallizes this transformation: the $11.3 billion buy-out of SunGard Data Systems, Inc. by a who’s who private equity consortium of Silver Lake Partners, Bain Capital LLC, Blackstone, Goldman Sachs Capital Partners, KKR, Providence Equity Partners LLC, and Texas Pacific Group (TPG). In order to understand SunGard and the origins of private equity’s downfall, though, we need to go further back in time to KKR and its foundational role in private equity.

  KKR and the Origins of Private Equity

  The beginning of private equity is probably best traced to a 1976 proposal Jerome Kohlberg and first cousins Henry Kravis and George Roberts presented to their employer, the now-defunct investment bank Bear Stearns. The trio had spent the last decade building a niche investment banking practice. The entrepreneurs who had built post-World War II family businesses were beginning to retire. At the time these businessmen had limited choices for exiting the businesses they had built and nurtured. Extraordinarily high federal inheritance taxes made simply willing these businesses to the next generation an unattractive prospect. In many cases, the inheritance tax would force a sale of the company and eat up an inordinate share of any gains on the disposition.The only two other choices were thought to be to sell the business, either on the public markets or to a more sizable and willing corporation. In both cases, many of these companies were either unsuited to go public or unable to find a corporate buyer.The owner would also lose control of the company he had built from scratch, a horrifying prospect.4

  Jerome Kohlberg had an idea to provide another option. In 1965, he put this idea in practice by orchestrating the buy-out of Stern Metals, a dental supplies company, for $9.5 million. A group of investors bought a majority position in the business for $500,000. This was the equity financing. The remainder of the capital for the purchase came from borrowed funds, so-called debt financing. The selling family, led by their 72-year-old patriarch, did not entirely exit the business. The family still retained an ownership stake, as well as operational control of the business. The deal turned out to be very profitable, and four years later, the family sold their remaining stake in a public offering. The family earned $4 million on their four-year reinvestment.5

  In the Stern Metals deal, the ad hoc group of new investors intended to cash out at a future date but leave the family owners in place. The result would permit the family owners to continue to run their firm but monetize a significant portion of their ownership.The family owners of Stern decided to sell early and take the
ir profits, but Kohlberg’s goal was to provide an avenue for families to stay and maintain control. Kohlberg would later cite this as his key innovation.6 Retention of the family as owners in the posttransaction structure strongly incentivized these managers to succeed and earn an outsize return for their new investors. Kohlberg took the cousins Henry Kravis and George Roberts under his wing and mentored them in the structure and completion of these family deals. The three quickly developed a thriving practice within the corporate finance department at Bear Stearns.

  In the early 1970s, Kohlberg, Kravis, and Roberts added a second type of deal to their repertoire.The conglomerate takeover wave of the 1960s had faltered. These big companies almost uniformly underperformed the market, while the managers of the individual companies chafed under the supervision of often less experienced senior executives and the byzantine management organizations governing these conglomerates. Meanwhile, institutional investors preferred to diversify through separate investments suitable to their preferences rather than through a conglomerate that often owned weak-performing assets hidden within its jumble of companies. Wall Street, ever quick to change its tune, began to agitate for the disassembling of these empires. The conglomerates themselves responded by disposing of the companies they had only recently bought. By 1977, fully 53 percent of all U.S. takeovers were conglomerate divestitures.7

  Kohlberg began to structure buyouts of these companies based on the structure he had first tested with family businesses. Kohlberg would strike up a relationship with the management of these subsidiaries. He would then arrange a group of investors to buy the subsidiary from the conglomerate. Debt was used for the bulk of the financing, and management would be included as posttransaction owners of the now independent entity.

  By 1976, things were going swimmingly. The trio had built a sizable and profitable business within their department at Bear Stearns. Moreover, the structure of these deals had been tested and found successful. Kohlberg and his lieutenants no longer had to spend hours explaining the workings of these transactions to unfamiliar management. You can just hear the conversation: “A leveraged buy-out, now what the hell is that?”

  Kohlberg felt it was time to establish a bigger platform to support their work. The three submitted their proposal to do so within Bear Stearns. A new department would be created within the investment bank, with Kohlberg as the head and Kravis and Roberts as his lieutenants. This would provide them the latitude they needed to organize and possibly fund these deals internally. In what was in hindsight a particularly bad decision for the investment bank (not its last), senior management at Bear Stearns declined the proposal. The three promptly departed to set up their own firm. Kohlberg invested $100,000; Kravis and Roberts $10,000 each.8 The firm was originally to be named “Kohlberg Roberts Kravis,” according to their seniority at Bear Stearns. But public relations advisers nixed the idea because KRK didn’t have the right ring to it; thus KKR was born.9

  KKR had a slow start. In 1977, KKR completed three buyouts, and in 1978 none.10 These buyouts were structured like the old deals. KKR did not initially have a source of committed capital. Wealthy investors were instead brought in for each deal to provide the needed equity investment. This limited KKR’s ability to make significant acquisitions. Each time KKR wanted to complete a buy-out, it needed to spend laborious hours putting together a new investing consortium, the elements of which would substantially affect the structure of their deals. But the trio was working to change this, putting in place another key element for an active private equity buy-out market.

  In 1978, KKR raised the first ever private equity buy-out fund. It was a meager $32 million in size but included as investors such notables as AllState, the insurance company;Teachers Insurance, the pension fund; and Citicorp, the commercial bank. Considering the economic conditions of the time—the prime rate would climb to 11.75 percent by year-end, and corporate lending would become increasingly scarce—it was a remarkable achievement.The fund also had a slightly different purpose. It was to invest in underperforming public companies, an area KKR had pegged as one where they could realize the greatest value.11 The fund had the common features seen in the mega buy-out funds of today: a 1.5 percent management fee (these days rising to 2 percent) and a 20 percent cut of the profits above a hurdle rate were paid to the fund’s general partners, Kohlberg, Kravis, and Roberts.The fund also contemplated administration fees that KKR would reap on each deal, including a fee of 1 percent of the transaction value for each deal paid as an investment banking fee and a fee of $20,000 per associate to serve on the board of the newly acquired company.These administration and dealmaking fees would later become an important source of revenue for private equity.12

  KKR now had dedicated funds to finance the equity portion of its buyouts. It would not have to go through the laborious process of raising equity capital on a case-by-case basis. KKR quickly put this money to work. In the next year, KKR partners completed its fifth buy-out, the $380 million buy-out of New York Stock Exchange-listed Houdaille Industries. This was the largest leveraged buy-out to date and extraordinary for the time. It was the first buy-out of a midsize, publicly traded company. 13 Again, the structure of future private buyouts lay in the framework of this landmark deal. The equity financing came from the KKR fund and friendly co-investors. Management also retained an interest in the now-private company, an incentive for them to achieve excess returns for their new investors.

  The acquisition was highly leveraged, with 87 percent of the financing for the deal coming from debt financing. Previously, KKR had been hampered in completing larger buyouts because of the lack of willing debt financiers. For example, KKR’s first transaction, the 1977 leveraged buy-out of A.J. Industries, had a total market value of $26 million.14 KKR was unable to raise any subordinated debt financing for this acquisition. Instead, KKR was limited to financing 66 percent of the deal with senior bank debt.15 In the Houdaille buy-out, KKR succeeded in implementing a capital structure that supported an approximately 85 percent debt-to-equity ratio but also inovatively allocated this debt to a variety of different financing instruments. But it had taken almost a year for KKR to raise these funds. Henry Kravis would later reminisce: “Literally we had to add up the potential capital sources at that time, which consisted of several banks and insurance companies, and one-by-one go out and raise the money, and then create a capital structure based on availability of funds.”16

  To make buyouts of greater size, KKR needed more debt and equity financing. This would become the lifeblood and driver of private equity. The investors in KKR’s first two funds in 1978 and 1980 were mostly wealthy individual investors.Their assets would not be sufficient to fund the increasingly larger buyouts KKR was targeting. Again, KKR innovated turning to a new source of untapped wealth, pension funds, and an older, more traditional one, commercial banks. In KKR’s next four funds, raised in 1982, 1984, 1986, and 1987, commercial banks invested approximately 30 percent of the total amount. 17

  Pension funds would provide an even more bountiful source of wealth. In 1974, Congress had enacted the Employee Retirement Income Security Act to promote the formation of private and public pensions and encourage private individuals to save for retirement. Since that time, public pension funds had accumulated hundreds of billions in assets under management. However, state laws at the time severely restricted the ability of these public pension funds to invest and typically prohibited equity investments as too risky. Oregon State Treasurer Bob Straub successfully lobbied his state legislature to lift these restrictions in order to gain the chance to earn higher returns.18

  This was a boon to both Oregon and KKR. The Oregon Council, headed by Roger Meier, became KKR’s first big investor, putting $178 million in KKR’s 1981 leveraged buy-out of the Oregon-headquartered Fred Meyer Inc. The total value of Fred Meyer was only $420 million. The council’s investment paid off, returning more than 53 percent on its investment.19 Other state pension funds rapidly took notice of Oregon’s leap, the ear
nings potential in buyouts, and KKR’s early returns and also convinced their legislatures to permit investment in these funds. Pension funds quickly became KKR’s biggest investors. In KKR’s $1.6 billion 1986 fund, state public pension funds accounted for a significant portion of the funds committed, including a single $55 million investment by the New York State pension fund, which later upped its investment in KKR’s 1987 fund to $370 million.20

  The performance of private equity in the 1980s, as well as the increasing prominence of their transactions, established private equity’s bona fides. Though the returns were not fully known at the time, the first five KKR funds earned an average return of almost 37 percent.21 Meanwhile, other leveraged buyouts were succeeding. In 1982, the management of Gibson Greetings Inc., a subsidiary of the conglomerate RCA Corp., arranged a leveraged buy-out of their own company for $80 million. The overwhelming portion of this was financed by debt, $79 million.22 Only a year later, the company went public, selling 30 percent of itself with a price that valued the company at more than $330 million. 23 In the wake of KKR’s Houdaille acquisition and the home run in Gibson Greetings, a host of other buy-out shops began to achieve public prominence. These included Forstmann Little, which acquired the Dr. Pepper Company in 1984 for $512 million.