Background information about the buyout: Barbarians Revisited (Bloomberg, April 1995)

http://www.bloomberg.com/bw/stories/1995-04-02/barbarians-revisited

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In 1988, when leveraged buyout artists Kohlberg Kravis Roberts & Co. began their historic takeover battle for RJR Nabisco Inc., the specter of the "barbarians at the gate" seizing control of one of the country's preeminent companies made celebrities out of Henry R. Kravis and George R. Roberts and spawned a best-selling book. Valued at some $25 billion, it remains the largest LBO ever.

On Mar. 20, when Goldman, Sachs & Co. succeeded in quietly selling the last of KKR's shares in the company, the reaction was considerably more muted. RJR Nabisco Chief Executive Charles M. Harper, in a just-issued annual report, trumpeted the end of "the leveraged buyout era at RJR Nabisco," but the company says it did nothing special to mark the occasion. And over at KKR, "there was no commemoration" of the two companies' parting, says a spokeswoman.

No wonder. In pure investment terms, the RJR Nabisco takeover was a sort of Waterloo for KKR. The buyout firm acquired RJR Nabisco at $5.62 a share on an adjusted-cost basis; it unloaded its final 8% stake for only about $5.73 a share. The bulk of KKR's stake likely sold for around the same price. Even KKR doesn't claim investors made money on the deal--though the KKR spokeswoman notes that KKR "did preserve their investors' equity."

Cold solace for the investors who bought into the 1987 buyout fund that KKR used to acquire RJR Nabisco. "It's too bad they devoted a lot of time, energy, and our dollars to an investment that has done so poorly," says Chuck Hunter, investment research manager of the Montana Board of Investments. "We're not exactly enthralled."

"SWEET DEAL." Of course, the $126 million the KKR partners themselves invested in RJR Nabisco didn't appreciate in value, either. Take into account the nearly $500 million in transaction, advisory, and other fees it charged, though, and KKR's return on the RJR Nabisco deal looks far better. It reaped a $75 million transaction fee from RJR Nabisco on the original deal and an additional $60 million over the years for advising the company. Then there were the $2.3 million in directors' fees the KKR partners, who served on the RJR Nabisco board from 1989 through 1994, pocketed personally.

But the biggest chunk of the money stems from a 1.5% annual management fee KKR assessed on the 1987 LBO fund until 1992, when the last of the fund's money was invested. The portion of this fee associated with the RJR Nabisco deal alone added a further $279 million to KKR's coffers. KKR "had such a sweet deal," says Harvard business school investment banking professor Samuel L. Hayes. "Investors [in its buyout fund] got the short end of the stick." And those investors can't pull out of the fund: Under terms of their deal, KKR gets to control most of their money until at least the end of the decade.

To be sure, KKR has a plan for recovering from the RJR Nabisco imbroglio. It has transferred its investors' money into Borden Inc.--and is hoping its buyout fund will reap a huge payoff from turning the troubled food company around. In a deal first announced in September and made final in March, KKR took Borden private. As part of the deal, KKR transferred its RJR Nabisco shares to cash-starved Borden, which sold them and used the proceeds to pay down debt and strengthen its balance sheet. C. Robert Kidder, formerly CEO of Duracell International Inc., one of KKR's most successful companies, was tapped to head Borden.

KKR maintains that investors in its 1987 fund haven't fared poorly. That's because other KKR acquisitions, including Duracell, Stop & Shop Cos., and Fleet Financial Group, have performed better than RJR Nabisco. For one, Duracell's shares have more than doubled, to $44, since it went public in May, 1991.

All told, estimates James Parker, executive director of the Washington State Investment Board, the 1987 fund returned 12.2% compounded annually as of Sept. 30, the most recent accounting available--vs. a 9.7% compounded annual return for the Standard & Poor's 500-stock index during the period. But the fund's return has likely dropped since last fall: RJR Nabisco shares were trading at 67/8 on Sept. 30 and fell as low as 53/8 over the winter, as KKR's shares were sold to fund the Borden buyout. Given the high risk, "that's not what we were expecting," says Parker.

KKR's big challenge now is to make Borden pay off. "The Borden acquisition represents a unique and creative solution to a difficult investment that didn't live up to our original expectations," says KKR partner Paul E. Raether. Indeed, KKR paid less than $2 billion for the Columbus (Ohio) company, which is home to such well-known brands as Cracker Jack and Creamette pasta. Less than four years ago, Borden had a market value of nearly $6 billion. But there were no other takers when Borden put itself up for sale more than a year ago. And even with better management and lower debt, Borden will be hard to get back on track, analysts think. Kidder, who has no previous food industry experience, declined to be interviewed.

WORTH IT? The bigger heartache for KKR may be that it sold out of RJR Nabisco too soon. Under KKR's whip, it has shed more than 46,000 employees since 1988 and sold off $6.2 billion worth of businesses. Even so, its return on equity fell from 24% to 16% from 1988 through 1994--largely because of price wars in the tobacco industry. Meanwhile, RJR Nabisco's market value fell from $25 billion in 1988 to $21.1 billion now. Given all that, KKR argues its investors will make more from a Borden turnaround than they would have from RJR Nabisco.

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But that may be a heck of a target to beat: Harper, who had a stellar record as CEO of food giant ConAgra, has set a goal for RJR Nabisco to earn a 20% return on invested capital. And Harper isn't alone in thinking the company's fortunes are on the upswing. It succeeded in selling 19.5% of its Nabisco foods business to the public as a separate stock in January, and most investors anticipate that Nabisco will be completely spun off at the end of 1996. Sanford C. Bernstein & Co. analyst Gary Black contends that in a few years, investors will see that "KKR bought at the high and sold at the low." Even Hunter is accumulating RJR Nabisco shares for Montana's investment board.

In the end, a single question remains: Given the thousands of layoffs, the financial machinations involved, and the sheer egotism, was the signal takeover of the rip-roaring '80s worth all the fuss? The answer: Only if you're a KKR partner.

TOTING UP THE TAKEOVER

INVESTORS FARED BADLY The KKR fund put $3.1 billion into RJR Nabisco at $5.62 a share on a cost-adjusted basis. Six years later, the last of the fund's shares were sold for about $5.73 each. Shareholders also got $40 million of KKR's fee for the Borden acquisition.

...BUT KKR EARNED HUGE FEES The partners' own investment of $126 million didn't appreciate. But the firm earned nearly $500 million in transaction and other fees. That includes a 1.5% management fee that came to $279 million over five years.

ANATOMY OF A BIG DEAL

The tortured history of the 1980s' most infamous LBO

NOVEMBER, 1988 With Henry Kravis intent on winning the biggest takeover battle ever, KKR buys RJR Nabisco for $25 billion, considerably more than what the company had been valued at a few weeks earlier. All but $1.4 billion of the purchase is financed with debt.

JULY, 1990 To shore up RJR Nabisco's finances, KKR has to inject $1.7 billion in equity into the company.

APRIL, 1993 On Apr. 2, "Marlboro Friday," Philip Morris slashes the price of cigarettes because of stiff competition from low-cost brands, throwing all tobacco stocks into a tailspin. RJR Nabisco's stock drops 25%, to about $6. To help, ex-ConAgra Chief Executive Charles Harper is tapped in May as RJR Nabisco's new CEO.

APRIL, 1991 KKR sells 14% of RJR Nabisco's equity to the public for $1.3 billion, or $11.25 a share in new stock.

SEPTEMBER, 1994 KKR offers to buy Borden with $2 billion in RJR Nabisco stock, collecting a $50 million fee for itself. KKR still owns 17.5% of RJR Nabisco.

JANUARY, 1995 RJR Nabisco successfully spins off 19.5% of its Nabisco food unit as a separate stock. KKR taps former Duracell CEO C. Robert Kidder to run Borden.

FEBRUARY, 1995 KKR injects more RJR Nabisco shares into Borden to shore up that company's troubled balance sheet. KKR now owns 8% of RJR Nabisco.

MARCH, 1995 KKR unloads the last of its RJR Nabisco shares for about $5.73 a share, vs. the average of $5.62 a share it paid for the company.

Then cover the following topics carefully in your case report:

A brief summary of the case.

Discuss why the company is a good LBO candidate. What were the valuations? How did they come up with the valuations?

Discuss the risks associated with LBOs, and how the buyout turned out for KKRs investors and other stakeholders.