08/06/22, KKR and RJR Nabisco

Jun 08, 2022

Hello all, and welcome to day two of this journey. I’ve had a great time hearing from many of you, and the feedback has been far more positive than I was expecting. Going forward, I’m going to try to segment these into smaller, more digestible bites. When I send these out, I’m imagining you guys reading these during a commute, a break, or a slow period of work. So, it makes sense that you can attack these articles in small chunks over time. With that being said, let’s jump in!

Outline

Today I’ll be talking about one of the most notorious leveraged buy-outs of all time: KKR’s $25b LBO of RJR Nabisco. Let me set the scene: we’re deep into the 1980s, where low-interest rates, deregulation and globalisation have led to a swelling of buyouts, corporate activity and general capitalistic excess. For references in pop-culture, look no further than American Psycho or Bonfire of the Vanities.

On the acquisition side, we have a rapidly growing private equity fund, KKR, led by Henry Kravis. These guys were the pioneers of using large amounts of debt to acquire large companies, selling assets after acquisition to pay down the debt, and thus gaining large equity stakes with minimal personal investment (an LBO in its purest form).

On the defender side, we have RJR Nabisco, an inefficient, extremely large tobacco and food producer (odd mix, borne out of a desperate merger by cigarette company R.J. Reynolds who sought to diversify away from the increasingly regulated tobacco industry).

Timeline

1985: R.J. Reynolds (tobacco) mergers with Nabisco (food). We see Nabisco CEO F. Ross Johnson already looting company coffers for private jets and expensive management perks. Spoiler alert: Johnson loses out by the end of this deal.

October 1988: Johnson proposes to take RJR Nabisco private at a $17.6b valuation. Why? Part greed (huge equity stake for Johnson), part to avoid other corporate raiders taking advantage of the company’s low stock price, ailed by Tobacco lawsuits and general mismanagement.

6 days later, KKR make an offer at a $20.4b valuation. This bid is rejected and a bidding war begins.

November 1988: Throughout this bidding war, we see three parties emerge. Johnson’s management buy-out (MBO) goes as high as $112/share, KKR’s goes as high as $109/share, and rogue entrant First Boston offers a whopping $118/share. KKR is chosen, due to superior financing (likelihood of paying back debt without causing RJR Nabisco to become distressed) and a general disdain for Johnson, who was seen as a traitor and ‘black knight’ within the firm.

Time Magazine featured Johnson on their cover, with the headline:

‘A Game of Greed: This man could pocket $100 million from the largest corporate takeover in history. Has the buyout craze gone too far?’

Analysis

Why did KKR win the bid despite not being the highest bidder?

Despite KKR being the lowest bidder of the three parties, they still triumphed. Why? The answer goes to the core of why buyouts are so prolific: not only were KKR paying a high price relative to the stock price of RJR prior to the war (around $40/share), they had superior financing and strategic outlooks compared to the other bidders. The advantages of KKR can be summarised in three points

Asset sales: KKR only wanted to sell off $5b of RJR assets in the short-run; Johnson’s group planned to sell $13b. Boards and shareholders, logically, prefer to keep their business intact;
Buy-ins: KKR wanted to let 25% of RJR remain in existing shareholders hands, whereas Johnson only offered 15%;
Financing and strategy: KKR wanted to bring in fresh-blood, poaching executives from American Express, other food brands, and bringing in the respected J. Paul Sticht as CEO. On the other hand, the reigning CEO Johnson wanted to keep himself in power: a move unpopular due to his perceived disloyalty and inefficiency.

Anatomy of an LBO

A question loathed by consultants, lawyers, bankers and buysiders alike: ‘describe the steps of an LBO’. Few phrases spark such disdain amongst the stubble-ridden, eager, candidates lining the corridors of BCG, Clifford Chance, Goldman, or Blackstone. However, it is necessary to have an understanding of this financial mechanism, shown not least by the deal we covered today.

The process is actually pretty simple:

Calculate purchase price
1. Usually this is done through determining an EV/EBITDA (value to profit) multiple of industry of target company, then applying to target company’s EBITDA
Determine debt to equity ratio
1. Usually 4-8x EBITDA
Project cash flows of target company
Calculate enterprise value of company (exit sale value)
Calculate equity value (exit owner value)
1. Substracting future cash flows from debt used to fund deal, which gives debt that needs to be paid down once company is sold. The figure left represents the EV (enterprise value) paid back to investors at end of deal
Calculate returns (either IRR or MOIC)

This is a brief description, but further information is available in the further reading section.

Thank you for reading!

Well, that wraps up day 2 of the operation. I thought I’d take the time to comment on the traction of this newsletter. Starting yesterday, I thought I would gain 0 traction. Defying my expectations, we already count readers at Skadden, JP Morgan, LSE, Princeton and even the founder of a social enterprise. Nice. Let’s hope we can scale this up and keep pumping out useful, content to you dealmakers (current and future).

As always, if you would like to recommend this newsletter to others in your office or university, I would be eternally grateful.

Best,

Alex

The North Star

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