Book: Barbarians at the Gate
Author: Bryan Burrough, John Helyar
Key takeaways:
This is a story about leveraged buyout of RJR Nabisco, a large conglomerate. The buyout was preceded by a bidding war between the management (led by the CEO, Ross Johnson), KKR, the storied private equity firm, and a few ‘smaller’ players. Leverage buyout often saddles the bought-out firm with a lot of debt, requiring the managers to cut costs (often including personnel)–this is why these are unpopular with the employees, general public and the popular press. This $31B buyout, eventually won by KKR was no different, especially because it was the biggest-ever LBO at the time. KKR leads today’s roster with the $44.4B buyout of TXU.
- Often excesses need a Big Insane Firm: The latest financial crisis had AIG, which was willing to be the ‘insurer’ side of many credit default swaps until it was too late, fueling the creation of CDOs (often requested by very people who wanted to bet against those CDOs). In the junk bond excess of 1980s, a similar role was played by Drexel Burnham Lambert, which helped market many of the junk bonds created for such transactions. Before Drexel, 60% of money raised was raised in form of secured debt from commercial banks, 30% from a handful of insurance companies, and rest from the new owner. Drexel’s junk bonds made it possible to bypass the slower insurance companies and get faster players involved, and this transformed the takeover industry.
- Taxman, what have you done?: Arguably the key advantage of LBOs is the tax advantage that comes with having a heavy debt burden. A large amount of debt means a large amount of interest expenses, which in turn means very little net income, and hence a tiny silver of taxes. Many don’t like LBOs because often the operating profit of the firm bought out ends up diverting interest payments to investors instead of ending up as tax money (lower interest => higher profit => higher taxes).
- PIK Stock: In middle of the bidding war, Ross Johnson, the CEO of RJR Nabisco, makes a great comment. “Hey, why don’t we start a new company, and it’ll be all PIK? I wonder if I could pay all the advertisers, or buy space in Time. This we could it in PIK? I mean, we have found something that’s better than the U.S. printing press. And they’ve got it all down here on Wall Street. And nobody knows it’s going on. You could solve the third world debt crisis with this stuff. It’s a brand new currency…”
PIK is Payment in Kind loan, where the borrower doesn’t pay cash interest for a significant part of the bond’s life, often offers to pay in stock to allow the lender share the upside. These and other complex rules (some of which are described on http://en.wikipedia.org/wiki/PIK_loan) make it a very risky type of loan. Without such loose terms, it would have been very difficult to finance such deals. - What did CEOs learn from LBOs? Dick Beattie said that CEOs learned that the way to immense wealth was through equity ownership, not salary/bonuses.
- Sundry Interesting Corporate Tidbits
- Nabisco once fought a turf war with P&G and Frito in Kansas City by lowering and lowering prices, and though it lost money in Kansas City, it won the war in the end, because the other guys didn’t have the production and distribution systems to quickly go national, and were deterred by Nabisco’s desire to fight for the turf.
- Reynolds used to do something called “loading” where before the semi-annual price increases, the company would hold massive sale for suppliers, which suppliers loved because they could buy the product at low prices and sell at elevated prices.
- At one point, before Reynolds and Nabisco because together to form the conglomerate, Reynolds looked to acquire Kraft, but the stock was controlled by a trust and they doubted that the trust would sell.
- As a takeover defense, Ross Johnson had money for RJR Nabisco’s management parachutes placed in “rabbi trusts”, so that the new owners couldn’t touch these funds (rabbit trusts defer the taxability to the entity receiving payments such as employee compensation or purchase payments in an acquisition).
My closing thought: It is a great read, no doubt. It is not only very instructive to understand (at an elementary level) how the deals of this size were financed, but also to read how various financial firms got involved, and for what reasons (often more than just money).
Prasad Capital 