RJR-Nabisco; KKRackers

The Economist

Dec. 3 , 1988

AFTER one of the roughest battles in American corporate history, Kohlberg, Kravis, Roberts, a small but powerful buy-out firm, has been left in control of RJR-Nabisco -- and a host of questions. KKR's $ 25 billion leveraged buy-out for the tobacco and food giant is almost twice as big as the previous largest takeover. Is that too much? Its offer was preferred to one suggested by RJR's own managers. Whatever happened to the notion that LBOs are a way of giving existing managers an extra incentive? Above all, will the deal cause regulators to step in?

KKR's main rival in the six-week war was an investment group led by Mr. Ross Johnson, RJRNabisco's chief executive, and backed by Shearson Lehman Hutton, a Wall Street investment bank. This group initiated the bidding, and claims that its final bid was technically slightly higher than KKR's. But it was defeated by the rather bizarre bidding system. A special committee of outside directors appointed by RJR's board unanimously voted in favour of KKR.

The victory ensures KKR's executives' position as the "buy-out kings". The buy-out artist had already carried out the two biggest LBOs in history -- Beatrice foods and Safeway Stores -- and was loth to be usurped by Shearson in the biggest deal of all. Its purchase of RJR will increase the total revenues of all the companies it controls to more than $50 billion, making it the fifth biggest industrial company in America.

The fact that its willingness to pay such a high price may be motivated partly by the desire to stay number one, rather than corporate logic, is the main reason to worry that KKR might have paid too much. The final price was about 50% above the price the management-led group first offered and almost double the share price before bidding started. Over the past few weeks, RJR has been valued variously at $ 13 billion (by the stock market before the bids began), $ 17 billion (by the first bid), $ 29 billion (the highest bid, which was subsequently withdrawn) and $ 25 billion. This does not say much for the efficiency of capital markets.

The higher the premium paid, the bigger the debt burden that must be taken on to finance the deal, and so the greater the risk. The deal will saddle RJR-Nabisco with a total debt of more than $ 20 billion. The company will be dangerously vulnerable to weakening stock market, higher interest rates or a recession. Most economists expect at least one, if not all three, within the next two years.

KKR may have won the bidding war, but it may have a Pyrrhic victory; the real battle is yet to come. In the LBO war-game, you only win when you sell the company at a profit. The big test of the deal will be whether the post-buy-out company manages to sell off the assets it needs to pay off some of the debt at a decent price (ie, one not scandalously lower than the price of the asset implied in its own deal). And it still has to retain enough business to generate the cash flow to service the heavy debt burden.

And what of Mr Ross Johnson, the chain-smoking chief executive of RJR? It has been a baffling few weeks for a man who, when he proposed the LBO on the first anniversary of the October crash, must have thought that he was proposing rather a smart deal. He has found himself castigated by the local press in Atlanta (RJR-Nabisco's headquarters) and put on the cover of Time magazine as the epitome of the greedy manager willing to sacrifice his company in order to win himself $100m. In an early round of the bidding battle, KKR tried to compromise with Mr Johnson in an equity-sharing deal with managers and Shearson, with the aim of retaining Mr Johnson and other top executives. But the bitterness of the battle in recent weeks may make it hard for him to stay.

If he goes, it will be bad news for KKR. The most successful LBOs tend to be those where existing management stays on. Mr Johnson would have the confidence of management and employees -- a valuable asset when a firm is about to go through a radical shake-up and breakup. Second, KKR will need the experience of RJR's management to decide which assets can most profitably be sold to repay debt.

Most industry analysts expect KKR to sell off the food business (whose products include Winston cigarettes as well as Ritz and Animal crackers) either as a single unit or in bits, and leave RJ Reynolds tobacco as a private business. This is the best way to maximise the proceeds from asset sales and generate the biggest cash flow to repay debt. The stock market consistently undervalues tobacco companies, despite their rich cash flow. By keeping RJR's tobacco private, its excess cash flow should, fingers crossed, be sufficient to service the company's debt. Moreover, it is argued, no other big company would achieve significant economies of scale by buying RJR's tobacco business, and hence be prepared to pay a premium.

There is more scope for food companies, however, to achieve economies of scale in marketing and production. Many of Nabisco's brands also have dominant market share in growing markets and so fetch a good price.

Regulate, Regulate

The biggest question raised by the deal, however, is: will the new administration step in to limit LBOs? One of the main causes of the boom in LBOs is the American tax system: dividend payments are taxed but interest payments are not. Unsurprisingly, companies have used less of their cash for dividends and retained earnings and more for borrowing. Mr Alan Greenspan, the chairman of the Federal Reserve Board, has voiced concerns about this; congressmen have called for changes to the tax system so that debt and equity are treated equally. They may get their demands. A deal might be an easy way of smoothing the potentially strained relations between the new Republican administration and the Democratic Congress.

Behind these concerns is a wider one about the danger of over-indebtedness (see box) and the dangers of greed. A popular view is that it is being driven by the greed of Wall Street bankers rather than corporate logic. There is no doubt that investors and Wall Street firms earn fat fees from LBOs. And fears about the way the price paid for RJR-Nabisco has been pushed sky high cannot be dismissed lightly. However, history shows that LBOs can benefit the company taken private as well.

The discipline of debt forces managers to squeeze more value from the company by seeking efficiency, cutting costs and selling off inefficient operations. In previous LBOs KKR has usually given the managers some equity in the private firm, giving them even greater incentive to improve performance. A recent study by Mr Steven Kaplan of the Chicago Business School, confirms that profits usually do rise after a firm goes private through an LBO.

Critics warn, however, that LBOs overburden a company with debt. Cash which would otherwise be used for investment or research is diverted into interest payments. RJR-Nabisco may have to drop its costly efforts to market Premier, its no-tar cigarette. Mr Kaplan's study suggests, however, that any fall in capital spending tends to be small. And to the extent that heavy debt burden forces a firm to scrutinise its investment plans more carefully, the quality of capital spending may improve. Also, if RJR's food divisions were sold off to companies with fat wallets, they would surely be anxious to make their investments pay off.

So far the limited evidence is on the side of LBOs: they can help to make companies more efficient. It would be a pity if the RJR-Nabisco deal proves to have been overpriced and triggers legislation to halt what, for some companies, may be the best opportunity to improve their performance.

1. Why do critics frown upon leveraged buyouts?

2. What is KKR expected to do to help pay down the debt associated with its purchase of RJR-Nabisco?

3. Why do some worry that KKR may have bid too much for RJR-Nabisco?

4. Assume that RJR-Nabisco has pre-tax cash flows of $5 billion per year, with no growth expected in the future. In addition, the firm is subject to a 35% corporate tax rate, and KKR has determined that an appropriate discount rate for the firm is 18%. What is the maximum amount that KKR should have bid for RJR-Nabisco?