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

by Steven M. Davidoff

  Forstmann Little was headed up by the flamboyant Teddy Forstmann, who publicly juxtaposed himself against KKR and Henry Kravis as a more benign buy-out king, less interested in leverage and the restructurings that had arguably stigmatized private equity. Forstmann himself consorted with celebrities and politicians, enjoying the fruits of his wealth, yet he gave generously to philanthropic causes. He was also never afraid to speak his mind and made a point to do so, publicly criticizing the highly leveraged transactions KKR was undertaking and later decrying the use of high-yield financing. The fact that Kravis married dress designer Carolyne Roehm, whom Forstmann had previously dated, no doubt, added fuel to the fire.24

  Money was to be made in leveraged buyouts. But how was private equity able to earn money where independent corporate managers had not? People attributed the success to a number of reasons.

  • The Benefits of Increased Debt. The debt placed on these companies worked to discipline management. No longer could profits be spent on corporate outings or jets, but rather money was required to pay financing costs. Management was forced to strictly budget and account for their expenses in order to meet financing costs and to pay down debt. During the 1980s, KKR would typically attempt to finance transactions with 80 percent to 90 percent debt, with the remainder in equity. Debt also had a tax advantage.The interest was tax deductible, allowing a company to increase its excess free cash by utilizing debt financing.25

  • Increased Incentives for Management. The inclusion of management as equity investors strongly incentivized them to succeed. The money made on the Gibson Greetings transaction was an example all had seen and a large carrot. Before, corporate officers had a smaller stake in the success of their enterprise; their salaries were largely paid so long as they didn’t entirely fail. Now managers could profit handsomely, together with their investors. They had more skin in the game and so were willing to take more risk and had more incentives to perform.26

  • Greater Alignment of Ownership and Control. Private equity management itself was intimately involved in the operation of their acquisitions and constantly monitoring them for performance. KKR’s partners served on the boards of the companies they bought, where they scrutinized their company’s performance and constantly inquired and questioned management business decisions. This contrasted with the more laissez-faire approach in the public markets at the time when boards were largely passive, the members were often friends and colleagues of the CEO, and dispersed public shareholders lacked the capacity for concerted action.27

  • Diminished Regulation and Longer Term Operational Focus. Private equity allowed firms to operate outside the glare of the public markets. While the benefits to the public markets existed in increased access to financing, liquidity, and analyst and other disclosure coverage, they also subjected the public corporation to litigation exposure, disclosure costs, and other costs associated with regulatory supervision. A private corporation eliminated a measure of these costs.28 It also allowed the company to adopt a longer term focus over and above the next quarterly earnings report, which is too often the primary focus of public companies.

  • Longer Term Investing Horizon. Finally, private equity firms adopted long-term investing horizons. During the 1980s, the average length of time KKR held a stake in an acquired company was 7.6 years.29 This provided both management and their investors time to work with and influence the company. This long-term investment outlook permitted the companies in a private equity firm’s portfolio to focus on long-term investments and make decisions that, while painful in the short term, would result in greater long-term profits.

  KKR had succeeded in finding the equity for its deals. But an even greater portion of debt was needed to finance these ever larger transactions. Previously, KKR had relied on commercial banks and insurance companies for debt financing. The loans these entities were willing to provide were often only on a secured basis and at a senior level, meaning that they were paid first before any other debt. This limited the amount KKR could borrow to finance an acquisition. The acquired company needed to maintain a cushion of security to support this debt. Moreover, putting together this debt on a case-by-case basis made it harder to complete deals on a rapid time line, a necessity in the public markets.

  If KKR was going to obtain the leverage it desired, it was going to have to find a source for large amounts of unsecured or junior debt that could be quickly raised in tandem with secured debt.This is where the brilliant and infamous Michael R. Milken and Drexel Burnham Lambert Inc. came in.Throughout the 1970s and 1980s, the perpetually working Michael Milken had been creating a larger market for high-yield debt, often known as junk bonds because this debt was either unrated or rated below investment grade. Historically, high-yield debt was shunned by investors and confined to small issuers who had no other financing choice. Milken had studied this market and found that investors in this debt could earn outsize returns. He popularized this notion and soon convinced many institutional and other investors to purchase the high-yield debt issuances he organized.To feed this clientele, Milken needed an even larger source of issuers for these securities.

  The stars of Milken and private equity aligned. Not only could Milken provide a ready and rapid source of financing but also, by making this market in less secure, subordinated debt, he provided a means for private equity firms to raise more debt and increase leverage. Greater leverage on their acquisitions permitted private equity firms to make more frequent and larger buyouts and enhanced opportunities to earn outsize returns. In 1983, the leverage buy-out firm Clayton & Dubilier (now Clayton, Dubilier & Rice) became one of the first private equity firm to use Milken’s services for C&D’s leveraged buy-out of the graphics division of Harris Corp.The other private equity firms followed, and by the mid-1980s, with few exceptions they began to uniformly resort to Milken and his junk debt to finance their acquisitions; Milken’s annual high-yield debt conference became known as the predator’s ball in honor of their consumption. In doing so, Milken and private equity created a debt market that would support the quick sale and securitization of debt. 30

  Again, KKR was the market leader, forming a tight partnership with Milken and Drexel Burnham Lambert. The partnership and its potential were revealed in 1985, when KKR announced the takeover of the conglomerate Beatrice Foods Co. Beatrice had started in the dairy business but rapidly expanded in the 1970s and 1980s into a mishmash of other businesses, including La Choy Chinese foods and Playtex underwear. KKR’s unsolicited offer was made without the foreknowledge of Beatrice, then the 26th largest company on the Fortune 500 list. Before this offer, KKR had never completed a deal without management buy-in. It now joined league with the corporate raiders of the time, although Beatrice’s management was known widely for its incompetence, which made KKR’s leap easier. Beatrice rapidly capitulated, and the buy-out was completed at the record price of $6.2 billion. To finance this transaction, KKR resorted largely to Michael Milken and his junk debt machine and paid $248 million in banker and other fees associated with the deal.31 For the remainder of the 1980s, KKR would find easy financing for its buyouts. What bank wouldn’t want to make the hundreds of millions of dollars in fees KKR offered up in any deal? In the wake of Beatrice, KKR raised its largest fund to date: a $5.6 billion 1987 fund. Eleven pension funds ponied up 53 percent of this amount.32

  The private equity boom continued, and KKR remained at the epicenter of this activity. From 1985 to 1989, it completed only 28 buyouts of the more than 1,625 private equity buyouts that occurred. Yet, KKR’s buyouts numbered 8 of the 25 largest buyouts of the period and comprised nearly a quarter of all buy-out activity as measured by value during this time.33

  The buy-out frenzy of the 1980s appropriately crested in KKR’s record $31.1 billion 1989 deal for RJR/Nabisco, documented so well in the book Barbarians at the Gate. KKR won RJR only after an extended bidding war against a management buy-out group led by RJR CEO and ex-salesman Ross Johnson. It was a battle of wills in which Henry Kravis b
ecame determined to beat Johnson. Wall Street was in awe at the stratospheric price KKR paid and generally attributed it to Kravis’s need to show that he could not be beaten. The deal generated more than $1 billion in fees for the deal machine, including KKR and its armada of bankers and lawyers.

  In the wake of the RJR deal, the buy-out market cratered. The reasons were varied. The credit markets tightened, the United States entered a recession, and regulations surrounding the issuance of high-yield debt financing tightened. In addition, the S&L crisis eliminated many buyers for this debt, while the RJR deal itself was so large that it absorbed a substantial amount of future investment capacity. Many also cited a bubble in credit and private equity, which simply popped. Whatever the cause, the easy credit of the 1980s dried up almost overnight in 1989. The event was publicly marked in the travails of First Boston Corp. caught in its “burning bed.” When the market suddenly collapsed, First Boston was left unable to refinance the hundreds of millions it had lent to Ohio Mattress Company, the producer of Sealy mattresses, for a leveraged buy-out. First Boston escaped bankruptcy only via a bailout by Credit Suisse Group AG.34

  If there was any doubt that the go-go days of easy credit were over, at least temporarily, the very public imprisonment of Michael Milken on insider trading charges and the early 1990s implosion of Drexel Burnham Lambert cemented its demise. Nonetheless, KKR and Milken had succeeded in creating a machine for quick and sometimes cheap financing for buyouts. This would be the same machine that would engender the overleveraging of companies during 2004-2007 and savagely malfunction in the financial crisis of 2008.

  The failure of the debt markets was mirrored by a decline in equity funding for buyouts. New commitments to private equity fell from $11.9 billion in 1989 to $4.8 billion in 1990, and to $5.6 billion in 1991.35 Without an active source of financing, private equity firms struggled to make acquisitions. The value of private equity buy-out activity plummeted from $75.8 billion in 1989 to $8 billion in 1992.36 Private equity firms also encountered operational difficulties as they attempted to turn companies purchased at premium prices into profitable investments. KKR was not immune. KKR’s investors lost $958 million on the RJR deal, and in 1991, KKR was forced to invest an additional $1.7 billion into RJR/Nabisco to refinance $7 billion worth of pay-in-kind securities.The press widely covered this event, proclaiming that Kravis and KKR were reaping its “punishment” for hubris in overpaying for RJR, a result of its need to be seen as the deal community’s overlord.37

  There were lessons to be learned.The lifeblood of private equity was clearly debt and equity—the financing for these acquisitions.The drying up of these sources led to a quiet period for the industry. Moreover, the cyclicality of these financing sources, and thus private equity, was ably revealed.After the collapse of the high-yield market in 1989, it was quite clear that private equity activity was now dependent on the debt markets for survival. Moreover, the credit crash of 1989 showed that the credit cycle and private equity would eventually peak, as with all other cycles. The travails of First Boston ably showed what would happen when the game of musical chairs stopped and the debt market entered a downturn: Someone would be left holding the debt at a substantial, perhaps perilous loss.This was yet another soon forgotten lesson to be repeated in 2007 and 2008.

  In the wake of these excesses, private equity entered a quiet period. The 1990s were times of rebuilding. Deals continued to be had, but they were smaller, with a lower profile. Blackstone, Apollo Management L.P., the Carlyle Group, TPG, Thomas H. Lee, and Silver Lake all appeared as prominent players on the buy-out scene. KKR, though, continued to dominate the field. In 1996, it raised its biggest fund to date, $6 billion. KKR struggled to complete this fund, as investors still smarted from KKR’s late-1980s investments and competitors began to shadow the firm. The prospective investors bargained hard with KKR over the terms of this fund, citing the competition and the poor performance of RJR’s late-1990s investments. KKR was forced to reduce its management fee from 1.5 percent to 1.1 percent and cut in half its monitoring and transaction fees. The negotiation became so contentious that George Roberts reportedly told the giant California state pension fund CalPERS that they would not be welcome as investors because of their strident negotiating positions.38

  The credit floodgates opened after September 11, 2001, as the Federal Reserve aggressively—in hindsight, perhaps too aggressively—lowered interest rates. Debt financing became both cheap and freely accessible. This would trigger private equity’s renewed ascent. In 2001, private equity accounted for $17.6 billion in U.S. takeovers, but by 2006 private equity accounted for more than $389.5 billion in takeovers and more than 25.4 percent of all U.S. takeover activity.39 It was growth spurred not just by the availability of inexpensive debt. Private equity’s return was also aided by the continued rise of pension funds, endowments, and insurance funds and the equity financing they could provide. As of 2007, U.S. pension funds alone held $14 trillion in total assets and endowments $411 billion.40 These funds were voracious investors, scouring the markets for investments and excess returns. Once again, these funds eagerly invested in private equity firms who were looking to leverage the loose credit markets to increase the number and size of their acquisitions. In 2006, private equity funds raised $229 billion in commitments, compared with only $38 billion in 2002.41 In that year, Blackstone raised the largest private equity fund to that date, a $15.6 billion fund dwarfing KKR’s record $10 billion fund, also completed in 2006. KKR had been publicly dethroned (see Figure 2.1).42

  Despite its missteps, private equity could rely on its stellar historical track record dating from the 1980s to draw this investment. In its first 30 years, KKR had an annual average return of 20.2 percent net of fees on its first 10 private equity funds.43 Similarly, the emergent Blackstone earned an annual return of 30.8 percent on its investments gross of fees since the firm began in 1987.44 Although data were scarce and general studies were few and far between about the broader ability of the private equity industry, those available supported the conclusion that private equity was an industry of the large. The established, more sizable firms achieved excess returns consistently, with the bulk of smaller firms and the industry itself achieving earnings at best on par with the S&P 500 with adjustments for leverage.45 As in the 1980s, a few extremely profitable public transactions in the new millennium highlighted to the world the extraordinary potential of private equity investing. In 2005, Blackstone took public the Celanese Corporation, a German chemical company. Blackstone quintupled its $650 million investment in only 12 months.46 Not to be outdone, KKR, together with the Carlyle Group and Providence Equity, performed a similar investing feat in that year by selling PanAmSat Corp. less than 12 months after it was acquired to the tune of over $1.8 billion in profits.47

  Figure 2.1 Funds Raised by Private Equity Firms (Globally) 1999-2008

  SOURCE:Thomson Reuters (includes global buyout, mezzanine, recap, and turnaround funds)

  These investment funds were also drawn to private equity due to their focus on alpha. Alpha refers to the ability of an investment manager to earn excess returns over those predicted for an investment based on its prior response to market movements, or beta. Eliminating beta permits the manager’s performance to be evaluated on the quality of their investment selections and not on market movements. Private equity funds were found to historically provide superior risk-adjusted performance, or positive alpha, higher than that of matching leveraged investments in the S&P 500 Index.48 This was further evidence of the success of private equity in operating their businesses, and another key to again drawing in professional institutional investors.

  The frenzy of the 1980s began to repeat itself in the new millennium. As in the 1980s, private equity began its rise quietly, but as the boom continued, it became an increasingly larger force. In 2004, the largest private equity deal of the year was the $4.8 billion buy-out of Metro-Goldwyn-Mayer by TPG, CSFB Private Equity, and Providence Equity, in conjunction with Sony
Corporation.49 However, the largest U.S. private equity deal of all time was announced on February 26, 2007, when TPG, Goldman Sachs Capital Partners, and KKR agreed to the $4.3 billion buy-out of TXU.50 In 2006 and 2007, 9 of the 10 largest private equity buyouts of all time would be announced (see Table 2.1).

  Table 2.1 Ten Largest Private Equity Buyouts of All Time

  SOURCE:Thomson Reuters (completed buyouts)

  Private equity once again ventured into new territory as the buyout market simmered and then boiled. In the 1980s, these private equity buyouts were often affected by shell subsidiaries set up specifically for this purpose by the private equity firm. The shells had no assets of their own. Instead, the acquisitions agreements required that the shell use its reasonable best efforts to complete the buy-out. The shell could also often terminate the deal if financing was unavailable. This was accomplished by placing a financing condition in the acquisition agreement, conditioning the shell’s obligation to acquire the target on the shell having obtained sufficient funds to do so. But since the shell had no assets of its own, targets demanded assurances that the financing would indeed be available. So these arrangements were also accompanied by a debt financing commitment letter from an investment or commercial bank. These commitments were often less than complete, though, to be finished with documented credit agreements at the time of deal completion. These debt commitment letters were also optional and contained a market out clause permitting the banks to terminate their financing obligations if market conditions deteriorated or otherwise impeded placement of the debt.

  Because of the high leverage put on these transactions, banks were often unwilling to even provide this commitment. In such circumstances, a bank would issue a highly confident letter. These letters were first widely used by Michael Milken in deals where the success of the debt issuance was too uncertain to provide any firm written commitments. The financing bank would instead opine that it was “highly” confident that the debt could be raised in the markets but provide no contractual agreement to do so. In either case, though, the private equity fund itself was not liable if the transaction failed to complete. This effectively enabled the private equity firms to walk from the buyout anytime before consummation of the acquisition if market or other circumstances dictated. Targets generally relied upon the reputation of the firms and on private equity firms’ desire to complete the transaction to ensure their cooperation.