Barbarians at the Gate: The Fall of RJR Nabisco

Wall Street businessman Henry Kravis and his second wife, fashion designer Carolyne Roehm, were “the prince and princess of the newly moneyed set dubbed ‘Nouvelle Society’” (129). In the 1980s, Kravis’s “rise on Wall Street had been swift” (129). It was the LBO wave that allowed him to attain prominence. Kravis’s father, an immigrant from England, got rich in the 1920s and lost it all in the 1929 stock market crash. Kravis worked entry level jobs at Goldman Sachs in the summers when he was in college. He then attended the Columbia Business School “with an undistinguished record of Bs and Cs,” while working for the Madison Fund (131).

After graduation, Kravis worked at the brokerage firm Fahaerty & Swartwood for a year before starting to work for Bear Stearns. Kravis replaced his cousin, George Roberts, who relocated to the company’s San Francisco office. At 21, Roberts started working for Bear Stearns, a “cutthroat place” where he developed a friendship with Jerome Kohlberg, the head of the finance department (132). After Roberts’s departure, Kohlberg made Kravis his protégé.

Leveraged buyouts “began as a kind of aid to the elderly” (133). They were the “missing link” between companies remaining private, selling public shares, or selling to a bigger company as a way “to retain control of their firms,” while looking “for ways to avoid estate taxes” (133). Kohlberg’s first LBO took place in 1965 with the dental company Stern Metals, earning a significant return on investment. The high risk that came with the LBO financing model could sometimes be a spur to improvements in the business: “Because he borrowed heavily to buy companies, getting a fix on future earnings and cash flows was crucial if Kohlberg was to avoid having his loans called” (134). Companies became more efficient, and the “result was usually worth more than when he bought it” (134).

Unable to “set up a freestanding LBO group within Bear Stearns,” Kohlberg, Roberts, and Kravis announced their intention to leave the firm, as “things got nasty” (137). Bear Stearns attempted to “retain control of all Kohlberg’s deals, even though the three had millions of their own money sunk into them” (138). Kohlberg Kravis Roberts & Co (KKR) was born. Initially, “the deals were always friendly, always with management, always careful,” but came inconsistently (138).

Things changed in the early 1980s when KKR started doing more deals and receiving more media attention, as “the trio finetuned its craft” (139). Suddenly, “this ‘LBO thing’” started getting everyone’s attention on Wall Street (139). The number of LBOs grew significantly in the first half of the 1980s. LBOs “got off the ground” because the Internal Revenue Code made interest, rather than dividends, deductible from income that was subject to taxation, “What made them soar was junk bonds”—high-risk securities used to raise large quantities of capital quickly (140). By using junk bonds, “LBO buyers, once thought too slow to complete in a takeover battle, were able to mount split-second tender offers” (141). Firms like KKR became “white knights” saving companies attacked by raiders, “It was a symbiotic relationship repeated in deal after deal: raider seeks target; target seeks LBO; and raider, target, and LBO firm all profit from the outcome” (141). At the same time, some in business and government worried that LBOs might lead to more bankruptcies.

In 1984, Kohlberg had surgery to remove a blood clot in his brain and was unable to maintain the same workload. At the same time, Kohlberg and Kravis maintained very different lifestyles. Kohlberg was a homebody who was not changed by money, while Kravis “lived for the lush life” (144). Kohlberg did not like the “bad image” of nightly black-tie functions with the likes of Donald Trump. In turn, Roberts and Kravis thought that “Kohlberg wanted too much of both” money and power (144). Because of all these issues, Kohlberg left the firm in 1987 and founded his own Kohlberg & Co. with his son. In 1987, KKR decided to pursue megadeals to stand out from the crowd. However, in the wake of the stock market crash, some new deals continued to fail. It was then that Kravis started looking into Nabisco.

Carolyne Roehm (Jane Smith) started working for designer Oscar de la Renta after graduation from fashion school. She changed her name to her real first name, Carolyne, and got her last name from Axel Roehm to whom she was briefly married. In 1979, she met Kravis, but it was “not a storybook love affair” (146). Prior to marriage, Roehm and Kravis became business partners as Kravis invested in her design business. Their wedding was “one of the ‘twenty weddings of the century since 1980’” according to GQ. The pair was rich—between $200-350 million—but continued to work long hours.

Peter Cohen, of Shearson Mergers & Acquisitions, was the son of a clothing manufacturer in New York state. He graduated from Ohio State and Columbia Business School. By the time he was in his late twenties, he had two children. In 1984, supported by “the tremendous firepower of American Express,” Cohen bought Lehman Brothers Kuhn Loeb investment bank for Shearson. In the mid-1980s, Shearson pursued LBOs. Its Sheller-Globe deal landed Shearson executives under an insider trading investigation carried out by the Securities and Exchange Commission, “a tough introduction to LBOs” (156). In 1986, the firm hired Daniel Good, whose clients were corporate raiders. Some considered him “a glorified shakedown artist” (157). Good was responsible for the successful 1986 raid of Hammermill Paper, which netted Shearson $6 million in fees.

At this time, Ross Johnson began to consider an LBO—a possibility he had previously rejected. If the LBO happened, it would be the largest in history, and getting the deal would put Shearson “into the top ranks of merchant banking firms” with many “residual benefits,” such as reviving “Cohen’s moribund junk-bond department” (160). The fees would be massive and would come in for years. For the meeting with Shearson, Johnson brought along Horrigan, Sage, Henderson, and a Wall Street lawyer, Steven Goldstone from Davis, Polk & Wardwell.

The RJR Nabisco group knew the LBO process well. Typically, “central to the success of most LBOs is a ruse known as the ‘gun-to-the-head’ strategy” (162). The latter involves keeping the process secret until the deal is clear, then presenting the bid “as a take-it-or-leave-it proposal” by the chief executive to the board (162). However, Johnson wanted to change this standard strategy and approach the board to avoid “its wrath” (163). The Shearson group did not like Johnson’s approach but had no other choice. One of the biggest points of contention is that Johnson wanted to maintain control of the board as well as the power to veto strategic decisions and run the company as he liked. Shearson also feared that Kravis’s KKR was the only firm with “the combination of power, confidence, and money to mount a serious counterbid” (163). Another issue was whether there was enough LBO money in the world “that could be committed to a single buyout” (168). Shearson calculated its total potential availability to be $21 billion.

The negotiations between Johnson’s men and Shearson were more than tough. The former made the latter believe that they “stood ready to scrap the whole project, or, worse, take it to another investment bank” if they did not get their way (171). Shearson conceded a number of issues, like allowing Johnson to control most of the board and paying Johnson’s taxes. In Johnson’s view, “every negotiation was a fight,” and the proceedings were to be expected (173). Peter Atkins, a top security lawyer, was to represent the board. At this time, in contrast to RJR Nabisco’s plans, Philip Morris initiated a tender offer for Kraft, as “Hamish Maxwell had chosen to expand his empire rather than dismantle it” (176). As the negotiations stalled, Cohen and Johnson had a two-hour phone call late one evening in which “Cohen capitulated to virtually every demand” (179):

Typed up by Sage’s secretary that night, the management agreement gave Johnson’s seven-man group 8.5 percent of the equity, complete with a tax-compensated loan from Shearson. If Johnson hit all his “bogeys,” the group’s stake could easily march up to 18.5 percent. The package’s total value could go as high as $2.5 billion in the coming years. Johnson was free to divvy up his share of the pot as he chose; his personal 1 percent share—Horrigan also took 1 percent—could be worth as much as $100 million in five years, according to Steve Goldstone (179).

The agreement could be renegotiated should the share price exceed $75. The result “was unlike any major LBO agreement ever signed” (179).