Merchants of Debt: KKR and the Mortgaging of American Business--The Condensed Version

MERCHANTS OF DEBT:

KKR and the Mortgaging of American Business

BY GEORGE ANDERS

InkWell Publishing

Published in eBook format by InkWell Publishing at Smashwords

521 5th Avenue, 26th Floor

New York, NY 10175

Original Copyright 2013 by George Anders

eBook Copyright 2013 by George Anders

Cover Design by Gogashi Designs & Photography

All rights reserved. No part of this book may be reproduced in any form by any means without the prior written consent of the Publisher, excepting brief quotes used in reviews.

For Betsy

TABLE OF CONTENTS

Introduction

1. Courting CEOs

2. The Growing Allure of Debt

3. The Takeover Minstrels

4. Ruling an Industrial Empire

5. Cashing Out

6. Fear, Humbling and Survival

7. KKR Today

Sourcing and Acknowledgements

Introduction

What really goes on inside a big, secretive organization? I’ve always cherished the way legendary journalist Ernie Pyle recounted his first visit to the giant furnaces of Owens-Illinois Co. Right before your eyes you see a miracle, Pyle wrote. "A wheelbarrow load of sand, lime and ash is heated to 2,600 degrees. [It] gets fluid, about like molasses. And then, when you let it cool, instead of turning back to dirt again, as it should, it comes out clear and clean and brittle, like glass.

It is glass!

Decades later, I ended up at the headquarters of Owens-Illinois – and dozens of other companies, too – studying a modern-day alchemy even more astonishing than what Pyle described. Giant companies such as O-I were being hurled into a furnace of debt, as part of a curious new takeover known as a leveraged buyout. This was the financier’s equivalent of making glass. Stock-market listings vanished. Traditional profits went up in flames. What emerged a few years later was a gaunt, scaled-back company that somehow generated enormous profits for top management and an inner circle of people who arranged these deals. This transformation was both thrilling and terrifying. Somebody needed to make sense of it all.

For three years, getting to know the buyout business and the people who defined it became the greatest obsession of my career. The e-book that you are holding today is the updated result of that quest.

At the center of this story is Kohlberg Kravis Roberts & Co., the financial firm that created the buyout business in the 1970s – and then went on to devour Owens-Illinois and more than 200 other companies. KKR is famous for leading America on a daredevil dash into high-debt finance in the 1980s. The firm remains in the headlines, even today, having nimbly recast itself as a time-tested leader in what is now referred to as the global private-equity business. For anyone interested in corporate finance, economic history or the ways that tycoons make their mark, the rise of KKR is a story with enduring significance.

I reported this book during 1989 to 1991, which turned out to be a rare, propitious period. At that time, KKR’s founding partners, Henry Kravis and George Roberts, pulled back the curtain and told revealing stories about their work to a degree that hasn’t been matched before or since. The firm’s rise deserves a serious biographical history of its own, and this book is intended to serve that mission.

But there has always been a bigger story to tell, too. KKR’s saga illuminates the maneuverings and personalities of an era when debt ran wild. During KKR’s coming of age, progress no longer was measured by America’s ability to build better goods in its factories. Instead, the United States in the 1980s found itself in the midst of a legendary period of unchecked profiteering. What unfolded was a reincarnation of the Robber Baron era of the 1880s and the frenzied stock-market speculation of the 1920s – or perhaps an eerie foreshadowing of the subprime mortgage insanity of 2005 to 2007. In each case a money mania fed on itself, creating such a hypnotic illusion of prosperity that skepticism vanished until everything ended catastrophically.

So this book can also be read as a timeless exploration of conditions inside such a bubble. In the 1980s, the fastest fortunes were created by financiers who seized control of America’s showcase companies in takeover battles. Wall Street’s own prosperity became all absorbing, as stock-market averages tripled from 1980 to 1989, and a ten-year bull market added more than $2 trillion to Americans’ paper wealth. Giant public corporations turned into acquirers’ private fiefdoms, to be run or dismantled in whatever way would make the new owners even richer.

Supposedly careful bankers got caught up in this giddiness. They stopped financing highways or factories, in favor of lending billions to pay for KKR’s acquisitions. Alpha males on Wall Street became takeover minstrels, touring the United States in their pinstripe suits to clear the way for KKR’s next takeover. Nervous corporate chief executives worried about losing their jobs in hostile takeovers. So when crisis struck, these CEOs embraced either the ebullient Kravis or the coolly analytical Roberts as their rescuer. Meanwhile, many thousands of employees paid the price for buyouts’ success: austerity and layoffs that arrived as part of the so-called discipline of debt.

Although a few threads of this story begin before World War I, most of the adventure covers a modern, four-decade span. Kohlberg Kravis Roberts opened for business in 1976, with just $120,000 of its partners’ capital and some tawdry metal furniture left by the offices’ previous tenant. Rapidly, KKR grew into a takeover machine with an appetite unlike anything American business had ever seen. In the 1980s, the firm completed nearly $60 billion in acquisitions, snapping up companies as diverse as Safeway Stores, Duracell, Motel 6, Stop & Shop, Avis, Tropicana, and Playtex. In late 1988, Kravis and Roberts prevailed in a rough-and-tumble takeover battle that let them claim the biggest prize of all: RJR Nabisco Inc., maker of Oreo cookies, Ritz crackers, and Winston, Salem, and Camel cigarettes. They paid $26.4 billion for the company’s stock (or $31 billion if assumed debt is counted, too), carrying out the largest takeover in history.

KKR bought companies with such rapidity and élan that at one point, when KKR was contemplating four multibillion-dollar buyouts at once, the Federal Reserve Board’s head of banking supervision, William Taylor, paid a rare private visit to KKR’s Manhattan offices. Did the world banking system contain enough ready cash, Taylor asked, to finance the firm’s acquisition desires? The answer: Yes, but it was getting tight.

Even more audacious than the size of KKR’s appetite was the way it bought these companies. Nearly every cent used for its acquisitions was borrowed—either from banks, from buyers of risky new securities known as junk bonds, or from pension funds that became part-owners of companies being acquired. The KKR partners drew upon only trivial amounts of their own money in gaining control over businesses that employed nearly 400,000 people, enough to fill two congressional districts. Ordinary language no longer sufficed; a special vocabulary had to be created to describe KKR’s work, beginning with a new term for its acquisitions: leveraged buyouts. In this new world, pushing a company deeply into debt wasn’t dreadful; it was desirable.

How did an acquired company’s new owners make money in spite of the heavy debt involved? Tax savings played a big role, thanks to the deductibility of interest expense. Efficiency steps and cost-cutting helped jack up profit margins, at least for a few years. And a long-running bull market made almost any business appear more valuable with the passage of time.

Because buyouts were orchestrated by small groups, they reversed a nearly fifty-year trend toward economic egalitarianism in the United States. Suddenly power and riches were shunted toward a tiny elite. A few impresarios at the center of a buyout could control a giant company’s money-making capacity, by drawing upon borrowed money and borrowed management talent. Risk and responsibilities were left in lesser people’s hands.

The author William Greider once observed that in the U.S. system of democratic capitalism, there is a natural tension between those two words: ‘democracy’ and ‘capitalism.’ Much of American business history is shaped by this unending tug of war. The most durable business structures—such as the public corporation with many thousands of small shareholders, or the community bank dedicated to financing local growth—reflect a workable union of profits and populism. Buyouts, however, have proven to be an entirely different story. They simultaneously amounted to one of the finest capitalist ideas of the century, and one of the most profoundly undemocratic ventures that the United States had ever seen.

Kravis and Roberts have built up personal fortunes of more than $3.5 billion apiece, winning them spots high on Forbes magazine’s list of the 400 richest people in the U.S. Yet the two men – first cousins and lifelong friends -- have shrewdly invited their allies to share small pieces of KKR’s good fortune. Anyone who could help KKR achieve its ends was courted with an air of elegance, friendship, and intimacy. This coalition-building, as much as any financial maneuvering, was at the heart of the buyout firm’s success and its appeal in the business world. Time and again, Kravis and Roberts made it very attractive for other people to work within their system.

By their own admission, the KKR executives knew little about day-to- day management of the companies they pursued or acquired. Remarkably, they portrayed that as a virtue, rather than a shortcoming. We’re financial people, not operating people, Kravis repeatedly told chief executives. We don’t know how to run a company. We’d only mess it up if we tried. We’re counting on you. At such times, Kravis seemed refreshingly self-effacing. But his modesty concealed the buyout firm’s colonial- style grip on the businesses it owned. In KKR’s world, a helper could be found to perform almost every task, from shining the partners’ shoes to running RJR Nabisco.

Top executives at acquired companies were allowed to buy large amounts of their companies’ stock, and then told that either big riches or a near-total loss of their money awaited them depending on how skillfully they increased operating profit and reduced debt. Grab a man by his W-2 and his heart and mind will follow, a KKR associate once quipped. Sure enough, senior executives would storm through their companies the first year or two after the buyout, taking once- unthinkable steps to increase the enterprise’s economic value. Virtually any retrenchment—including shutting down factories, firing workers, or selling off subsidiaries en masse—was hailed as good if it made more money for a company’s new owners.

Far outside this lucky ownership circle, production workers and low- level managers watched in dismay as the buyout scythe cut through their lives. At Safeway, the loss-making Dallas division was quickly closed, and 8,600 workers were thrown out of work. At Owens-Illinois, a crusade to improve productivity grew so fervid that one low-level manager took on five different full-time jobs simultaneously. And at a machine-tool company that KKR owned, hourly workers went for six years without a pay raise. The efficiency of acquired companies became legendary, but so did stories of human anguish.

If history were simple, Kohlberg Kravis Roberts & Co. would have disappeared along with the 1980s’ Age of Leverage, wiped out in a financial downfall of its own making. In the spring of 1990, in fact, KKR did come much closer to ruin than almost anyone outside a few closed-doors meetings realized. The biggest acquisition of all time, the RJR Nabisco takeover, teetered close to the brink for three months, mired in financial troubles relating to its junk-bond debt. The story of that financial crisis—and the desperate rescue that KKR engineered—has been one of Wall Street’s most closely kept secrets. It emerges here for the first time.

As the final chapter explains, the path that KKR set in its first 15 years of operation is, by and large, the same road that the firm follows today. There have been plenty of modern-day expansions and diversifications, as well as a genteel renaming of KKR’s main pursuit. Kravis, Roberts and their colleagues prefer to portray themselves now as specialists in private equity, rather than leverage buyouts. Yet the firm’s rare blend of jovial warmth and icy precision remains as potent as ever. After all, the founders have mastered much more than finance in their pursuit of riches. Kravis and Roberts have also relied on two of the most enduring American characteristics of all: a handshake and a smile.

1. Courting CEOs

In the autumn of 1973, most people in Greensboro, North Carolina, had no idea of the troubles that gripped one of their leading businessmen, 46-year-old Bill Jones. On the surface, everything about his life looked fine. He was president of a profitable brick company that was expanding every year. He was increasingly being referred to as a community leader— joining the board of trustees at Greensboro College and leading a Boy Scout fund-raising drive. His marriage to the daughter of the brick company’s former chairman was thriving. And in a part of the United States where storytelling is a prized art, Jones knew how to spin tales that would make his friends laugh, sputter, or shake